WTO REGULATION OF SUBSIDIES TO STATE-OWNED ENTERPRISES (SOES)

– A Critical Appraisal of the China Accession Protocol

Julia Ya Qin*

Either China commits to privatize and liberalize its SOEs over the next decade, or the fabric of the WTO will be ripped. The operation of a giant state-owned sector, protected by numerous barriers and enjoying unusual privileges, functioning alongside private enterprise in the world trade and investment system, is bound to cause tremendous friction.1

- Gary Hufbauer (1998)

China’s government-owned, or state-operated or owned, enterprises are a big challenge to the system, and it is hard to believe this will not shape some of the thinking about subsidies. ... one can predict that in a couple of years some of the definitions in the subsidies code will have to be revised, if that is manageable.2

– John H. Jackson (2003) The dire warning by Hufbauer before China’s accession to the World Trade Organization (WTO), and the intriguing prediction by Jackson thereafter, both speak to the issue of subsidies to state-owned enterprises (SOEs). The existence of a large number of SOEs in China has apparently been perceived as fundamentally incompatible with the world trading system. However, exactly what are the special problems caused by SOE subsidies for the world trading system? To what extent are the standard WTO subsidy disciplines inadequate to address the issue of SOE subsidies in China and why? How are the problems regarding SOE subsidies addressed by the China Accession Protocol3 (the China Protocol or the Protocol), which sets out the terms for the application of the WTO Agreement to China? Is the Protocol approach effective in addressing the problems? And what are the implications of the Protocol approach for the WTO legal system? There has not been much discussion concerning these questions.

* Assistant Professor, Wayne State University Law School, Detroit, U.S.A. Email: ya.qin@wayne.edu. The author wishes to thank Alan Schenk, Wing Thye Woo and Li Jing for their inspiration and valuable suggestions, the two anonymous members of the JIEL Editorial Board for their helpful comments, and Milan Hejtmanek for his insightful observations and editorial assistance. This study benefited from research funding provided by Wayne State University Law School. All views expressed in this article, as well as any errors and omissions, are solely those of the author. 1 Gary Hufbauer, ‘China as an Economic Actor on the World Stage: An Overview’, in F. Abbott (ed.), China in the World Trading System: Defining the Principles of Engagement (Kluwer Law International, 1998) 47, at 50. 2 John H. Jackson, ‘The impact of China’s accession on the WTO’, in D. Cass, B. Williams & G. Barker (eds.), China and the World Trading System (Cambridge University Press, 2003) 19, at 26. 3 WTO, Protocol on the Accession of the People’s Republic of China, WT/L/432, 10 November 2001.

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This article offers a preliminary discussion of these and related issues. It proceeds as follows. Section I introduces the subject of subsidization of SOEs in the context of WTO disciplines. Section II turns to an overview of the SOE situation and various types of SOE subsidies in China. Section III reviews the Protocol provisions that directly or indirectly regulate Chinese SOEs and government subsidies to them. Section IV provides a critical analysis of the key Protocol provisions and examines the legal and policy implications of the Protocol approach towards the issue of SOE subsidies. A summary conclusion is set out in Section V together with certain specific recommendations. I. WTO Rules Regulating SOE Subsidies Government subsidization of state-owned enterprises is subject to the general WTO disciplines set out in the Agreement on Subsidies and Countervailing Measures (the SCM Agreement), which supplements relevant provisions of Articles VI and XVI of the General Agreement on Tariffs and Trade (GATT).4 With the exception of the China Protocol, WTO disciplines do not contain separate rules on subsidization of SOEs. Nonetheless, the SCM Agreement does provide certain exceptions that are particularly relevant to such subsidies, and WTO case law has dealt with the issue in the context of privatization of SOEs. In addition, GATT regulation of state trading enterprises and the lack of WTO rules regarding subsidies in so-called non-market economies (NMEs) also have a direct bearing on the issue of subsidization of SOEs. A. The Basic Disciplines The basic WTO disciplines regarding subsidies have two major components. First, they limit the freedom of governments to use subsidies in domestic economies. Second, they regulate the use of countervailing measures so that such measures will not become trade barriers in themselves. The object and purpose of the SCM Agreement is ‘to strengthen and improve GATT disciplines relating to the use of both subsidies and countervailing measures, while, at the same time, recognizing the right of Members to use such measures under certain conditions.’5

It has long been recognized that, while subsidies are widely used by governments to promote

objectives of national policies, they may cause adverse effects to the interests of other countries in international trade. Three such effects have been identified: (i) subsidies may lead to displacement of imports in the subsiding country; (ii) subsidized products may displace otherwise competitive domestic products in the importing country; and (iii) subsidies may cause displacement of otherwise competitive exports from third countries.6

Based on their potential trade effects, the SCM Agreement divides subsidies into the

categories of prohibited, actionable and non-actionable subsidies. Export subsidies are prohibited in light of their undisputed adverse effects on trade. Domestic subsidies are actionable if they are ‘specific’ to an enterprise or industry or a group of enterprises or industries and are shown to cause

4 The GATT and the SCM Agreement apply to trade in goods except for agricultural products which are subject to the special arrangement in the Agreement on Agriculture. Rules on subsidies to service sectors are yet to be negotiated under the General Agreement on Trade in Services (GATS). See GATS, art. XV. 5 Appellate Body Report, United States –Final Countervailing Duty Determination with respect to Certain Softwood Lumber from Canada (‘US – Lumber CVD Final’), WT/DS257/AB/R, adopted 17 February 2004, para. 64. 6 See John H. Jackson, The World Trading System: Law and Policy of International Economic Relations, 2nd ed. (The MIT Press, 1997), at 280-1.

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adverse effects to the interests of another Member. Non-actionable subsidies include non-specific domestic subsidies and certain narrowly-defined specific subsidies.7 Remedies are available at the WTO multilateral forum for all three kinds of adverse effects of subsidies. With respect to adverse effects of subsidies on domestic producers, the importing Member may also resort to countervailing measures under its national law in accordance with Part V of the SCM Agreement.8

Key to WTO subsidy disciplines is the definition of a subsidy under the SCM Agreement. In accordance with Article 1.1, a subsidy is deemed to exist if there is a ‘financial contribution’ by a government, or any form of income or price support in the sense of GATT Article XVI, and thereby a ‘benefit’ is conferred. A financial contribution is specified as a direct transfer or potential direct transfer of funds (such as grants, loans, equity infusion, and loan guarantees), foregone government revenue otherwise due (such as tax credits), provision of goods or services other than general infrastructure, or purchase of goods by the government.9 Though the term ‘benefit’ is not defined in the SCM Agreement, the Appellate Body has held that whether a ‘benefit’ has been conferred is to be determined by a comparison with marketplace benchmarks.10

An issue concerning SOE subsidization has been raised in the context of determining a benefit

conferred. Specifically, the question is whether a benefit originally conferred by a government subsidy to former SOEs continues to exist after the SOE was completely privatized at arm’s length and for fair market value, so that the products of the privatized firm should continue to be subject to countervailing measures imposed on the basis of the original subsidy.11 The Appellate Body has held that there is a rebuttable presumption that a benefit ceases to exist after such a privatization, and that whether the benefit derived from a pre-privatization financial contribution actually extinguishes after privatization depends on the facts of a particular case.12 WTO case law in this respect may have a significant impact on issues of SOE subsidies in China, as will be discussed below. B. Two Exceptions Relating to Subsidization of SOEs.

While WTO disciplines do not distinguish subsidization of SOEs from that of private entities, the SCM Agreement contains two exceptions relating to SOE subsidies. They are (a) the exception for subsidies granted by a developing country member in connection with a privatization program, and (b)

7 According to Article 31 of the SCM Agreement, the rules regarding non-actionable subsidies are subject to provisional application of five years. These rules lapsed by the end of 1999, and it is unclear whether they will be revived. 8 Only one form of relief may be used against such effect. SCM Agreement, footnote 35. 9 Ibid. 10 ‘[T]he marketplace provides an appropriate basis for comparison in determining whether a “benefit” has been “conferred”, because the trade-distorting potential of a “financial contribution” can be identified by determining whether the recipient has received a “financial contribution” on terms more favorable than those available to the recipient in the market.’ Appellate Body Report, Canada–Measures Affecting the Export of Civilian Aircraft (‘Canada – Aircraft’), WT/DS70/AB/R, adopted 20 August 1999, para. 157. 11 See Appellate Body Report, United States – Imposition of Countervailing Duties on Certain Hot-Rolled Lead and Bismuth Carbon Steel Products Originating in the United Kingdom (‘US –Lead Bars’), WT/DS138/AB/R, adopted 7 June 2000; Appellate Body Report, United States –Countervailing Measures Concerning Certain Products from the European Communities (‘US – CVD on EC Products’), WT/DS212/AB/R, adopted 8 January 2003. 12 US-CVD on EC Products, ibid., paras. 126-127.

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the exception for subsidies used by a transition economy member to facilitate its transformation from a centrally-planned into a market economy.

1. Subsidies Granted by Developing Countries in Connection with Privatization

Recognizing that subsidies may play an important role in the economic development of developing countries, the SCM Agreement provides developing country members with special and differential treatment in a number of instances.13 Such treatment includes extended transition periods to phase out export subsidies, less rigorous rules on actionable domestic subsidies, more favorable de minimis rules for terminating countervailing investigations, and an exception for subsidies granted within a privatization program.

The exception for subsidies granted for privatization purposes is directly relevant to

subsidization of SOEs. Article 27.13 of the SCM Agreement provides:

The provisions of Part III [Actionable Subsidies] shall not apply to direct forgiveness of debts, subsidies to cover social costs, in whatever form, including relinquishment of government revenue and other transfer of liabilities when such subsidies are granted within and directly linked to a privatization programme of a developing country Member, provided that both such programme and the subsidies involved are granted for a limited period and notified to the Committee and that the programme results in eventual privatization of the enterprise concerned.

This exception, however, does not apply to countervailing measures taken in accordance with

Part V of the SCM Agreement. Thus, the actual scope of this exception is limited to the exemption of such subsidies from actions based on the import-displacement effect and the export-displacement effect in a third country market. So far, little WTO interpretation has been reported under Article 27.13.14 It is unclear, for example, whether privatization includes partial as well as full privatization, or what constitutes ‘a privatization program’ for purposes of Article 27.13.

2. Subsidies Granted by Transition Economy Members

Article 29 of the SCM Agreement, Transformation into a Market Economy, allows ‘Members in process of transformation from a centrally-planned into a market, free-enterprise, economy’ to apply programs and measures ‘necessary for such a transformation.’15 Such members are given a seven-year transition period from the date of entry into force of the WTO Agreement to phase out export subsidies prohibited by Article 3, and the export subsidies so phased out and notified to the WTO are not subject to WTO action. Additionally, during the same period, domestic subsidies granted by such members in the form of direct forgiveness of government-held debt or grants to cover debt repayment are not actionable, and all other forms of specific domestic subsidies are only partially actionable, at the WTO.16 Moreover, in exceptional circumstances these members may be authorized to depart from 13 See SCM Agreement, art. 27. 14 In US – Lead Bars, the United States relied heavily on Article 27.13 to support its view that subsidies bestowed prior to privatization remain actionable and allocable to the production of the surviving privatized company. The Panel rejected its argument on the ground that Article 27.13 does not apply to countervailing duty cases. See Panel Report, WT/DS138/R, para. 6.76. 15 SCM Agreement, art. 29.1. 16 See Articles 6.1(d) and 27.9 which apply via reference in Article 29.2.

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their notified subsidy programs and their time-frame if such departures are deemed necessary for the process of transformation. Like Article 27.13, the Article 29 exception does not apply to countervailing measures taken in accordance with Part V of the SCM Agreement.

The Article 29 exception is particularly relevant to the issue of SOE subsides. Transition

economies invariably inherit a large number of SOEs from the era of their central-planned economies, and restructuring of SOEs is typically a major component of their economic reform. Programs and measures used by governments to carry out such reform, however, could be deemed as specific domestic subsidies actionable under the SCM Agreement.17 For instance, in order to restructure an SOE for sale to private investors, the government may forgive government-held debt or provide grants to cover such debt owed by the SOE. Alternatively, the government may transfer the shares of an SOE to employees or outside buyers at a nominal or discounted price, thereby making a financial contribution to the new owners of the privatized entity. Article 29 permits transition economy governments to apply such and other measures ‘necessary’ for the transformation of their economies and provides limited immunity to such measures from WTO action for a seven-year period. Though the exact scope of the provisions remains unclear,18 the provision is clearly intended to allow transition economy members extra flexibility in using subsidies, including subsidies to SOEs, to achieve their objectives in economic reform.

C. Connection between SOE Subsidization and State Trading The only WTO provision that explicitly refers to state-owned enterprises is GATT Article XVII, State Trading Enterprises. State trading is a separate issue from that of subsidization of SOEs, but there is also a certain connection between them.19

It has long been recognized that state-owned enterprises, or any enterprises granted special

privileges by the government, might be operated so as to ‘create serious obstacles to trade.’20 For instance, the government may, through its ownership control or the granting of special rights or privileges, direct such enterprises to favor products from one country over another, or artificially limit the quantity of imports, thereby evading the non-discrimination principle and market access commitments. Accordingly, GATT Article XVII provides that if a member establishes or maintains ‘a State enterprise, wherever located,’ or grants to ‘any enterprise, formally or in effect, exclusive or special privileges,’ such enterprise shall, in its purchases or sales involving either imports or exports, act in a manner consistent with the general principles of non-discrimination.21 This provision is understood to require such enterprises to make all such purchases and sales ‘solely in accordance with

17 If the transition economy member is also a developing country, such programs and measures may also be exempted under Article 27.13 of the SCM Agreement as subsidies to assist privatization. The exception provided by Article 29 is broader in scope than Article 27.13, but is limited to the seven-year period. 18 No jurisprudence or decision of a competent WTO body exists under Article 29. See WTO Analytical Index: Guide to WTO Law and Practice, 1st ed. (2003), Vol. 2, at 976. 19 See generally, Gary N. Horlick and Kristin H. Mowry, ‘The Treatment of Activities of State Trading Enterprises under the WTO Subsidies Rules’, in Thomas Cottier & Petros C. Mavroidis (eds.), State Trading in the Twenty-First Century (The University of Michigan Press, 1998), 97. It was observed, however, that little research had been done on relations between WTO rules on state trading and those on subsidies and countervailing duties. Werner Zdouc, ‘Comments’ in Cottier & Mavroidis (eds.), ibid., at 151. 20 GATT Art. XVII:3. 21 GATT Art. XVII:1(a).

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commercial considerations.’22 Article XVII is intended to ensure that members do not use state trading enterprises to escape or circumvent their GATT obligations.23

One way in which a government may use state trading enterprises to affect trade is to provide

subsidies through such enterprises. For instance, the government might instruct a state trading enterprise to purchase wheat from domestic farmers at a certain price and then sell the wheat at a lower price in international markets. The difference in prices is effectively a government subsidy. In fact, it has been pointed out that in a market economy the only way a government can affect trade through SOEs unequipped with monopoly rights is to subsidize economic activities.24 That is so because when an SOE must compete with other firms in the same market, the government could only influence the SOE in such a manner that results in lowering the price of the SOE products. If the government instructs the SOE to raise the price or limit the quantity of its products, such instruction would have little practical effect since the competing firms would displace the SOE’s market share.25

Thus, it appears that, in a competitive market environment, the main trade-distorting effect of state trading is that of government subsidization. GATT Article XVII, however, does not address this concern. The trade effect of subsidization through state trading operations is left to be disciplined by GATT Article XVI, the SCM Agreement and relevant provisions of the Agreement on Agriculture.26

D. The ‘Non-Market Economy’ Problem: An Unaddressed Issue

The entire WTO subsidy disciplines are based upon market economy norms and, as such, they cannot be applied meaningfully to centrally-planned or non-market economies, i.e., economies in which all production, distribution and external trade are controlled by the government instead of by supply and demand in the marketplace. In a typical NME, all or substantially all enterprises are state-owned.

Given the nature of an NME, the concept of government subsidization is theoretically

inapplicable to it. That, however, does not necessarily mean there is no distortion by government action in allocation of resources in an NME country that may adversely affect the interests of other countries. The problem is how to identify and measure such ‘hidden subsidies’ when there is no market benchmark in the NME. The SCM Agreement is completely silent on the subject. Fortunately, the issue has become much less significant in the post Cold-War era when most (former) NME countries have abandoned the model of central planning and moved to transforming themselves into market economies. Nonetheless, the fact remains that an NME WTO member, such as Cuba, does not

22 GATT Art. XVII:1(b). According to the Appellate Body, ‘subparagraph (b) [of Art. XVII:1], by defining and clarifying the requirement in subparagraph (a) [of Art. XVII:1], is dependent upon, rather than separate and independent from, subparagraph (a).’ Appellate Body Report, Canada – Measures Relating to Exports of Wheat and Treatment of Imported Grain (‘Canada – Wheat’), WT/DS276/AB/R, circulated 30 August 2004, para. 91. 23 See Panel Report, Canada – Wheat, WT/DS276/R, paras. 6.39, 6.89 and fn. 133; Appellate Body Report, Canada – Wheat, para. 85 (stating Art. XVII:1(a) is an ‘anti-circumvention’ provision). 24 See Frieder Roessler, ‘State Trading and Trade Liberalization’, in M.M. Kostecki (ed.), State Trading in International markets (The MacMillan Press Ltd., 1982), 261, at 264. 25 Ibid. 26 See Panel Report, Canada – Wheat, above note 23, paras. 6.104, 6.105; Appellate Body Report, Canada – Wheat, above note 22, para. 98 and fn. 105 (identifying various other GATT provisions that may apply to state trading enterprises (STEs) and stating that ‘Article XVII was never intended to be the sole source of the disciplines imposed on STEs under that Agreement.’).

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have any enforceable obligation under the SCM Agreement.27 A member wishing to bring a WTO action against Cuban subsidization of exports would have no rule to follow. Hence, whether and how to deal with NME subsidization is left to the discretion of individual members under their national countervailing laws. So far, there has not been much practice concerning NME subsidies.28

Interestingly, the absence of marketplace benchmarks in NMEs has never prevented importing

countries from applying antidumping measures to imports from NMEs, despite that it is equally impossible in theory to determine whether an NME has ‘dumped’ its products given that the concept of dumping is also based on the existence of market benchmarks.29 In practice, countries have typically used a third country price or even the importing country price of a like product as the normal value of an import from an NME in determining dumping and dumping margins. In contrast with its silence on the issue of NME subsidization, the WTO Agreement has explicitly provided for the possibility of applying antidumping rules to NMEs. The Antidumping Agreement specifically confirms the validity of an interpretive note of GATT Ad Article VI, which recognizes that in the case of imports from NMEs, ‘special difficulties’ may exist in determining price comparability for the purposes of GATT antidumping provisions and it may be necessary for members to deviate from the method of a strict comparison with domestic prices in the NMEs.30 The absence from the WTO Agreement of any reference to the use of countervailing measures against NMEs may be due to the lack of such practice by member countries. However, given that the distinction between subsidization (a government action) and dumping (a private subsidy) is meaningless as far as an NME is concerned, it does not seem to matter whether the remedy for injury allegedly caused by imports from an NME is provided in the form of antidumping or countervailing duties.31

It must be emphasized that GATT Ad Article VI refers to imports from a country ‘which has a

complete or substantially complete monopoly of its trade and where all domestic prices are fixed by the State.’ Very few such pure NMEs still exist in today’s world. In the post Cold-War era, a more compelling issue is how to apply WTO antidumping and subsidy disciplines in trade with former NMEs that are transforming into market economies. Unfortunately, the WTO Agreement has failed to

27 Cuba typically notifies to the WTO that it does not grant or maintain on its territory any subsidies falling within the meaning of Article 1:1 of the SCM Agreement and specific within the meaning of Article 2 of that Agreement. See e.g., WTO, Notification of Subsidies by Cuba, G/SCM/N/95/CUB (1 July 2003). 28 For the US policy of not applying countervailing measures to NME imports, see Jackson, above note 6, at 336-337. See also Robert H. Lantz, ‘The Search For Consistency: Treatment Of Nonmarket Economies In Transition Under United States Antidumping And Countervailing Duty Laws’, 10 Am. U.J. Int'l L. & Pol'y (Spring 1995) 993. The US practice seems to have influenced other countries in this regard. The situation, however, appears to be changing. See below text at notes 184 and 185. 29 See Lantz, ibid. 30 The Agreement on Implementation of Article VI of the General Agreement on Tariffs and Trade 1994, art. 2.7. For a brief account of the origin of GATT Ad Article VI, see Alexander Polouektov, ‘Non-Market Economy Issues in the WTO Anti-Dumping Law and Accession Negotiations: Revival of a Two-tier Membership?’ 36(1) J. World Trade (2002) 1, at 6-7. 31 This view seems to be reflected in Article 15 of the GATT ‘Subsidies Code’, which provides that a signatory country may choose either antidumping or countervailing measures to remedy alleged injury caused by imports from NMEs, and the calculation of the dumping margin or the amount of estimated subsidies in such case may be based on comparison between the export price and the price of the like product in a third country. See Agreement on Interpretation and Application of Articles VI, XVI and XXIII of the General Agreement on Tariffs and Trade, GATT BISD 26 Supp. 56 (1980). It is unclear why these provisions were not incorporated into the SCM Agreement.

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address this issue.32 With respect to subsidies, the system has opted to provide a limited exception for transition economy members under Article 29 of the SCM Agreement. II. The China ‘SOE Problem’ A. An Overview A large state-owned sector is a legacy China has inherited from the era of its centrally-planned economy. In contrast with most East European countries, which typically carried out large-scale privatization at an early stage of their economic reforms, China has never embraced mass privatization. Instead, it has adopted a gradual approach to marketization. Officially, the objective of China’s reform is to develop ‘a socialist market economy’, in which prices are set by the marketplace and public ownership dominates but coexists with private and other non-state sectors.33 Accordingly, China began to liberalize price controls from the early phase of its reform. By 1999, market prices had prevailed in 95% of all retail transactions.34 In the meantime, China has gradually reduced state ownership through policies that promote foreign investment, permit the development of private enterprises, transform collective enterprises into private ones, and allow sales and bankruptcies of SOEs. As a result, the SOE share in the national gross industrial output decreased from 76% to 28%, and its share in urban employment from 76% to 38%, in 1980-2000.35 Whereas SOEs remain dominant in heavy industries such as oil, power, metal, chemicals, and machinery, and service sectors including finance, insurance, rail and air transportation, telecommunications and medical services, the non-state sector, which comprises collectives, township and village enterprises, rural households, private firms, and foreign-invested enterprises, has become increasingly important in the economy.36 The price reform and the expansion of the non-state sector have subjected Chinese SOEs to increasingly intense market competition except where they have monopolies.

A basic problem with Chinese SOEs, however, is that they are largely inefficient.37 SOEs

traditionally have carried redundant employees and retirees on their payroll and have been obligated to provide ‘cradle-to-grave’ social services to workers and their families. Many SOEs are technologically

32 For a thorough analysis and criticism of antidumping practice of WTO members regarding transition economies, see Polouektov, above note 30. 33 See the Constitution of the People’s Republic of China, as amended, art. 6 (‘The basis of the socialist economic system ... is socialist public ownership of the means of production, ... the State adheres to the basic economic system with the public ownership remaining dominant and diverse sectors of the economy developing side by side’). 34 Nicholas R. Lardy, Integrating China into the Global Economy (Brookings Institution Press, 2002), Table 1-3. Price Reform in China, 1978-99, at 25. 35 The SOE share in the national gross industrial output was 28.2% in 1999. See Lardy, ibid., at 15; Xiaolu Wang, ‘State-owned enterprise reform: has it been effective?’ Chap. 3 in Ross Garnaut and Ligang Song (eds.), China 2002: WTO entry and world recession (Asia Pacific Press, 2002), Tables 3.1 and 3.2 (Source: China Statistical Yearbook, National Bureau of Statistics). 36 See Wang, ibid., at 32. 37 See Lardy, above note 34, at 13-5, on profitability of state-owned industries. For a summary of China’s SOE problems, see Harry G. Broadman, ‘A litmus test for China’s accession to the WTO: Reform of its state-owned enterprises’, in Alan S. Alexandroff, Sylvia Ostry & Rafael Gomoz (eds.), China and the Long March to Global Trade: The accession of China to the World Trade Organization (Routledge, 2002), chap. 5.

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out-of-date and their products non-competitive in the market. It was estimated that one-half of SOEs were losing money between 1999 and 2001.38

Moreover, loss-making SOEs are at the root of the problem of non-performing loans in China.

For years, SOEs operated in a soft budget system in which they were entitled to receive credits from state-owned banks regardless whether they were able to repay them. This policy allowed many loss-making SOEs to stay in business and resulted in the accumulation of a large portfolio of non-performing loans at state banks. Based on official figures, non-performing loans at the four major state banks amounted to more than 17% of China’s GDP in 2003.39 Independent sources, however, have estimated the amounts of such loans to be twice as much.40 As state-owned banks still dominate China’s financial sector, the problem of their non-performing loans threatens macroeconomic stability of the country.

Over the last two decades, the government has taken a wide range of measures to reform its

inefficient state sector. These measures have included use of market-based incentive contracting; providing SOE managers with greater autonomy in operations including the rights to set prices for their products and to hire and fire workers; partial privatization of SOEs through foreign direct investment and listing SOE shares on Chinese and foreign stock exchanges; closing down small and medium-sized loss-making SOEs; sales of SOEs through mergers and acquisitions; consolidation of SOEs into large group companies; and various organizational changes in the government administration of SOEs. In anticipation of increased market competition after China’s WTO entry, the government has accelerated its reform efforts. Since 1997, 80% of small SOEs at the county level and 60% at the municipal level have been sold off to non-state enterprises, and hundreds of large SOEs were restructured and became listed on domestic or foreign stock exchanges.41 From 1995 to 2002, the total number of SOEs decreased by 40%;42 tens of millions of SOE jobs were eliminated.43 As a result

38 Broadman, ibid., at 48. 39 Such bad loans amounted to RMB1.99 trillion as of September 2003. News Analysis: ‘China’s big “four” eye commercial banks in real sense’, China Daily, 7 January 2004, available at www.chinadaily.com.cn. China’s GDP in 2003 is estimated at RMB11.669 trillion. See US-China Business Council, China Statistics and Analysis, available at www.uschina.org. 40 See Special Report on China, ‘More reward for risk, but no revaluation’, Financial Times, 16 December 2003, p. 3 (The official source estimated the non-performing loans accounted for 20% of the total assets of the big four state banks whereas independent estimates put such loans at over 40% of such assets). 41 Li Rongrong, ‘Continuously adjusting the layout and structure of China’s state economy, propelling Chinese SOEs to participate in international competition and cooperation’, keynote speech by Chairman of State-Owned Assets Supervision and Administration Commission of the State Council (SASAC) at the International Mergers and Acquisitions Summit in Beijing, November 19, 2003, available at www.sasac.gov.cn. 42 Ibid. It should be noted that government statistics on the exact number of SOEs is confusing. While Li reported that the number of state-owned and state-controlled enterprises reduced from 77,600 to 41,900, he also said that small and medium-sized SOEs reduced from 245,000 to 149,000 during the same period. Further, in the same speech, Li more than once mentioned ‘the 159,000 state-owned and state-controlled enterprises’ in China. 43 More than 30 million SOE jobs were eliminated between 1995 and 2000. See Wang, above note 35, at 32. And more than 11 million SOE jobs were cut during the year 2002. See International Labor Organization, ILO in China, available at www.ilo.org.

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of these efforts, overall SOE performance has improved.44 Total SOE exports have also increased, albeit at a lower rate than that of foreign-invested and other non-state enterprises.45

The reform measures, however, have not fundamentally solved China’s SOE problem. In fact, with the overall decentralization of government control over SOEs, some of these measures have given rise to serious new problems, such as asset stripping (de facto privatization of SOE assets by insiders), irresponsible borrowings by SOEs that result in mounting non-performing loans, tax evasion and other abuses of managerial powers. The overall SOE productivity remains lower than that of non-state enterprises.46 And it is uncertain whether the recent improvement in SOE performance will persist once the short-term effect of the reform measures wears off. Meanwhile, thousands of SOEs remain insolvent, and the non-performing loan problem at state-owned banks is yet to be resolved.

In a sense, China’s WTO accession is all about opening its inefficient state sector to foreign

competition, thereby accelerating the SOE reform. The comprehensive market access commitments China has made are bound to exert tremendous pressure on its SOEs.47 Its commitment to completely open its banking sector to foreign competition by December 200648 is particularly significant. In contrast with the marketization for production of goods and most services, capital allocation in China has yet to be rationalized through market forces. A small number of state-owned banks still dominate the financial sector; interest rates have not been sufficiently liberalized so as to enable the banks to differentiate terms for borrowers according to credit risks; 49 and capital markets are still in the early stage of development. The WTO commitment on financial services is forcing China to hasten its reforms in the financial sector, which in turn will affect all SOEs that are the traditional beneficiaries of the state-owned banking system.

The SOE reform is an on-going process. As of the time of this writing, the government has

just begun a new initiative to revitalize the Northeast Region, the traditional industrial base of China that has been plagued by a massive number of ailing SOEs. It may be years before the legal and social infrastructure necessary for a successful SOE reform can be fully established. Among other things, China needs to develop a rational financial system, to accelerate de-linking social services from SOEs to reduce their social burdens, and to develop a social security system to handle unemployment resulting from an increasing number of SOE bankruptcies.50 Whether the SOE sector can be successfully reformed remains to be seen. 44 In 2002, industrial SOEs realized profits of RMB220.9 billion (US$27 billion), a 163.6% increase from that of 1995. Li, above note 41. 45 For example, in 2002, SOE exports valued at US$122.8 billion, up 8.5% from the previous year, accounting for almost 38% of China’s total exports. In comparison, exports by foreign-invested enterprises reached US$170 billion in 2002, up 27.6% from the previous year and accounting for 52% of the total China exports, whereas collective and private enterprises accounted for 10% of the total exports during the same period, up 32.6% and 159.5% respectively from the previous year. Source: Ministry of Commerce of the People’s Republic of China, Statistics 2002, at http://www.mofcom.gov.cn. 46 As of 2000, SOEs commended more than 50% of the total investment in fixed assets, but produced less than 30% of the gross industrial output. See Wang, above note 35, Table 3.3. 47 See discussion in Section III below. 48 See Annex 9 of the Protocol, Schedule of Specific Commitments on Services, Part II.7B ‘Banking and Other Financial Services’. 49 Broadman, above note 37, at 59. 50 Ibid.

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B. Government Assistance in the Reform of SOEs

Throughout the era of economic reforms, central and local governments have provided direct or indirect financial assistance to the SOE sector. Conceptually, such financial assistance can be viewed as falling into three general categories: (a) subsidies provided to sustain and revive loss-making SOEs; (b) subsidies provided in order to privatize or otherwise restructure SOEs; and (c) subsidies provided to foster key SOEs. In practice, the distinction among these three types may not be clear as the functions of the subsidies often overlap. In addition, the central government has provided huge sums to major state-owned banks that have been saddled with massive non-performing loans associated with historical policy lending to SOEs.

1. Three Types of SOE Subsidies (a) Subsidies to help sustain and revive loss-making SOEs.

Large amounts of government subsidies have been provided to loss-making SOEs during the reform process. Many such enterprises, especially small and medium-sized ones, were eventually closed. Some have turned around after radical restructuring, while others are still struggling. A chief motivation for the government support of money-losing SOEs is to ease the political and social impact of massive layoffs. For example, according to the government, at least 2500 large and medium-sized SOEs, involving 5.1 million workers and 240 billion RMB of liabilities, remained effectively bankrupt as of November 2003 but would not be closed down immediately, due to the lack of provision for the bad loans and a proper social welfare system to deal with the consequences.51

Government assistance to loss-making SOEs has taken a variety of forms, ranging from

financial support to administrative means of protection. The main forms of financial assistance are budgetary and bank credits.

– Budgetary subsidies. Historically, the government funded SOEs directly through its budget.

During the reform era, budgetary funding has continued, although decreasing steadily in more recent years. Based on information contained in China’s notification to the WTO, the central and local governments together provided budgetary support to certain loss-making SOEs in the amounts equal to about US$4 billion each year in 1995-1998.52 Of the total budgetary subsidies approximately one-fourth came from the central government and three-fourth from local governments. Most of the central government subsidies went to textile, coal, metal, machinery, chemical, tobacco, oil, and light industries. The forms of budgetary subsidies were either grants or tax forgiveness.53

– Bank credits. SOEs are the chief customers of state-owned banks, which still dominate the financial sector in China. As previously noted, state banks were long required to provide credits to SOEs irrespective of their ability to repay them. Even after such mandatory policy lending was abolished in 1998, the state banks still often roll-over unpaid credits to SOEs automatically, and

51 Li, above note 41. 52 They were RMB32.8 billion in 1995, RMB33.7 billion in 1996, RMB36.8 billion in 1997, and RMB33.3 billion in 1998. (Note that the exchange rate between US$ and RMB stayed the same during this period). See Annex 5A of the Protocol. 53 Ibid.

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provide SOEs with lending priority over non-state enterprises. On the whole, state bank subsidies to SOEs are less transparent than budgetary subsidies, therefore more difficult to measure and monitor.54

An example of state assistance provided to sustain and revive SOEs is the reform of state-owned textile industry.55 The state-owned textile enterprises used to be a major contributor to China’s economic growth, but by the end of 1996 they became the biggest money-losing firms, due to mostly obsolete technologies and management. From 1998, the central government provided subsidies for firms to decrease the number of spindles in operation. For every 10,000 spindles eliminated, the company would receive a subsidy of RMB3 million and a further RMB2 million worth of loans at a discounted rate. As a result, a large number of workers were laid off, and companies incorporated new technologies and improved management. In addition, most of the government reserves designated to cancel bad debts in 1998 and 1999 went to the textile industry, which saved many textile SOEs from going bankrupt. The state also raised the rate of tax rebate for textile exports and adopted policy to expand domestic demand for textile products. These measures, combined with a sharp increase in international orders, were cited as contributing to the rebound of state-owned textile enterprises in 2000.56 (b) Subsidies to help privatize or restructure SOEs

As noted above, a large number of SOEs, especially small and medium-sized ones, have been sold off to the non-state sector. Many others have been restructured into joint ventures or share-holding companies in which the state may or may not retain a controlling interest. It was estimated that by the end of 2000, wholly state-owned enterprises only contributed less than half of the gross industrial output of all state-controlled enterprises.57 More sales and restructuring of large SOEs are expected in the next few years, either through mergers and acquisitions involving foreign and domestic private capital, or equity offerings in domestic and foreign capital markets.

The SOE restructuring programs have typically involved financial assistance from the

government. Such assistance includes various financial incentives to potential investors in SOEs and funding to cover social costs of the restructuring.

– Incentives for mergers and acquisitions. In order to encourage foreign and domestic enterprises to acquire SOEs, the government has made various financial incentives available to the buyers. For instance, the acquiring firm may be allowed to suspend interest payments on debts of the acquired SOE for a number of years, or the government may pay unemployment benefits to the surplus employees of merged enterprises for a certain period of time.58

54 China’s notification to the WTO contained in Annex 5 of the Protocol does not include a category on bank loans to SOEs. 55 See ‘China’s Textile Industry: From Becoming Profitable to Upgrading’, People’s Daily, Business section, 26 July 2000, at http://english.peopledaily.com.cn. See also, Mark Williams, Kong Yuk-Choi & Shen Yan, ‘Bonanza or Mirage? –Textiles and China’s Accession to the WTO’, 36(3) J. World Trade (June 2002) 577. 56 People’s Daily, ibid. 57 Wang, above note 35, at 32. 58 See Broadman, above note 37, at 61 (citing the practice of the Tianjin municipal government). Many of the SOE mergers and acquisitions were administratively arranged by the government rather than occurring according to market terms. Such forced mergers often do not lead to rationalization and lower production costs; instead, the more efficient firms can become saddled with the redundant workers and obsolete equipment of the less efficient. Ibid.

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– Repackaging SOEs for foreign direct investment or listing on stock exchanges. The SOEs

chosen for foreign direct investment or stock exchange listing have typically been restructured in advance so that they possess the most productive assets of the enterprises and are rid of redundant workers and other social welfare responsibilities for employees (such as running their own schools and hospitals). The ‘repackaging’ of the SOEs, however, requires the state to take over the financial burdens of their unproductive assets and social responsibilities, effectively subsidizing the repackaged SOEs.

It is difficult, if not impossible, to estimate the magnitude of such subsidies. No statistics are

available regarding them.

(c) Subsidies provided to foster key SOEs. During the reform process, the government has designated hundreds of large SOEs as State key enterprises, of which about 190 are ‘central enterprises’ that are placed under the direct supervision of the newly established State-owned Assets Supervision and Administration Commission (SASAC).59 A majority of the key enterprises are reportedly making profits.60 According to the SASAC, the central enterprises will be reformed into modern enterprises, and will grow in five designated areas including that of national security, natural monopolies, essential public goods and services, essential natural recourses, and pillar and high tech industries.61 Additionally, it is the goal of the SASAC ‘to cultivate 30 to 50 internationally competitive state-owned or state-controlled enterprise groups.’62 There is no doubt that the key SOEs will receive preferential treatment from the government. They may be given exclusive or monopoly rights in dealing with specific products, and priority in access to natural resources and other production materials. With respect to finance, they will receive from the government not only budgetary funding, but also low-cost credits via state-owned banks. It was reported, for example, that a major state bank issued the first US-dollar-denominated bond in China’s domestic market in 2003, and the proceeds (about US$500 million) were to be lent to SOEs to retire their existing high-cost foreign debts.63 In addition, SOEs are expected to be given future opportunities to borrow hard currency in the domestic market.64 While these measures may also be taken for monetary policy reasons, they have the effect of reducing the financial costs of the SOEs. 59 See SASAC, ‘China State-owned Assets Management System Reform Entering New Stage’, 22 May 2003, at www.sasac.gov.cn. 60 SASAC, ‘Realized Profits of the State Key Enterprises Kept Fast Growing During Jan. to Nov. 2003 and are estimated to exceed 360 Billion RMB for the whole year’ (reporting that 87 out of 499 key SOEs incurred losses by the end of November 2003), available at www.sasac.gov.cn. 61 See ‘SOEs to Have New Rules’, People’s Daily, 10 July 2003, at http://english.peopledaily.com.cn. 62 Ibid. This strategy appears to be originally modeled after that of the Korean chaebol, where the government had for years promoted the establishment of large conglomerates to be the pillars of the Korean economy. After the Asian financial crisis that exposed major problems of the chaebol model, the Chinese government has modified its stance towards conglomerates in favor of industrial logic. See John D. Langlois Jr., ‘Pressures on China from the Asian Financial Crisis’, in Alexandroff, Ostry & Gomoz (eds.), above note 37, chap. 7, at 117. 63 The bond was issued by China Development Bank in September 2003 through a public tender arranged by the People’s Bank of China. About 40 financial institutions participated in the tender, and the main subscribers were large state banks. The bond has a 5-year term with the interest rate set at 3.65%. See U.S Commercial Service - American Embassy, Beijing, China Commercial Brief, Vol. 2 No. 143, 24 September 2003, at http://www.buyusa.gov/china/en/ccb030924.html. 64 Ibid.

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2. Efforts to Tackle Non-Performing Loans at State-owned Banks To tackle the massive non-performing loan problem at state banks, the government has not only taken steps to reform the banking system, but also resorted to various financial means to improve the balance sheets of the banks. From 1994 to 2002, RMB199.54 billion (US$24 billion) were allocated to write-off non-performing loans of more than 3,000 bankrupt SOEs.65 In 1999, the four major state banks set up asset-management companies (AMCs), which were partially financed by the Ministry of Finance, to take over a portion of the bad debts. By early 2000, RMB112 billion of debts owed by 78 SOEs had been converted into equities held by AMCs, with hundreds of more SOEs had been approved for similar debt-to-equity conversion.66 In 1998, the government issued a special treasury bond of RMB280 billion to boost the capital adequacy ratio of the four state banks.67 In early 2004, the government took the unusual step of injecting US$45 billion (about RMB398 billion) from the nation’s foreign exchange reserve into two of the four major state banks, which are slated to be restructured into joint-stock banks and listed on foreign stock exchanges.68

Given the magnitude of the non-performing loan problem in China, a government bailout of

state-owned banks is both unavoidable and necessary in order to maintain the economic and political stability of the country. Such a government bailout, however, may give rise to subsidy issues under the SCM Agreement. Unlike loans provided by the state banks to enterprises, government transfers of funds to the state banks are not directly bestowed upon the producers of merchandise that can be made subject to anti-subsidy measures. Nonetheless, such transfers may, at least in two ways, affect a determination of whether loans from the state banks are actionable subsidies.

First, the government bailout may be viewed as an indication that the state banks involved are

a ‘public body’ within the meaning of Article 1.1 of the SCM Agreement.69 If a state bank is determined to be a public body, i.e., part of a government, then all loans issued by that bank will by definition constitute ‘financial contribution’ by a government. Needless to say, the implications of such a determination would be very broad – it would render all loans from the state bank susceptible to 65 Li, above note 41. 66 ‘112 Billion Yuan Debt So Far Converted to Equity’, People’s Daily, Business Section, 25 January 2000, available at http://english.peopledaily.com.cn. While the debt-to-equity swaps do not inject new cash into the SOEs, they effectively recapitalize the debt-ridden SOEs so as to provide them with a new lease on life. See Langlois, above note 62, at 112-3. It was reported that more than 87% of the SOEs that used debt-equity swaps had turned loss into profits in 2000. ‘Deepening SOE reforms’, China Daily, 2 February 2001, at www.chinadaily.com.cn. 67 Richard Janda and Men Jing, ‘China’s great leap of faith: telecommunications and financial service commitments’, in Alexandroff, Ostry & Gomoz (eds.), above note 37, chap. 6, at 73. 68 See News Analysis: ‘China’s big “four” eye commercial banks in real sense’, above note 39. 69 For example, in determining that the Korean Development Bank and certain other state-owned banks in Korea are government authorities for purposes of a countervailing duty investigation, the US Department of Commerce cited as one factor in their decision the fact that any net losses suffered by these banks are covered by the Government of Korea. Other factors considered by Commerce include government ownership, the stated purposes of these banks, and various aspects of government control over the activities of these banks. See US Department of Commerce, Decision Memorandum for the Final Determination in the Countervailing Duty Investigation of Dynamic Random Access Memory Semiconductors from South Korea, 68 Fed. Reg. 37122 (23 June 2003), p. 16. The U.S. decision in this investigation is being challenged by South Korea at the WTO. See WTO, United States – Countervailing Duty Investigation on Dynamic Random Access Memory Semiconductors (DRAM) from Korea, WT/DS296/2, 21 November 2003.

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countervailing investigations or WTO proceedings under Part II or III of the SCM Agreement. Moreover, it would frustrate the intent of the Chinese government to operate its state-owned banks as true commercial banks.

Second, the government bailout may give rise to the issue of indirect subsidization.70 Where

the state bank involved is determined to be a commercial bank instead of a public body, the benefit conferred to the state bank by a bailout may nevertheless be deemed to have passed onto its clients. Under existing WTO jurisprudence, when the initial recipient of a subsidy is not the same entity as the producer of the products subject to a countervailing investigation, the producer is an indirect recipient of the subsidy if it can be established that the benefit flowing from the subsidy is passed through, at least in part, to the producer.71 Where the two entities are unrelated and operate at arm’s length, the pass-through of subsidy benefits from the initial recipient to the producer may not be presumed; instead, a pass-through analysis is required to determine the extent to which the subsidy benefits are bestowed on the products in question.72 It is yet to be clarified whether the pass-through of the benefits can be presumed in the absence of arm’s length transactions between the two entities, and if so, whether the presumption is rebuttable.73 In any event, given that a state bank and its SOE borrowers are in theory related through common ownership, the burden may be on the Chinese producer under investigation to show that its borrowing from the state bank is an arm’s length transaction. 3. Potential Trade Effects It is generally not an easy task to assess the trade effects of domestic subsidies.74 In the case of China,

70 The concept of ‘indirect subsidization’ is not defined in WTO jurisprudence. It appears, however, that the concept has been used to describe at least two situations. First, an indirect subsidy exists when the government ‘entrusts or directs’ a private body to carry out a subsidy function within the meaning of Article 1.1(a)(1)(iv) of the SCM Agreement. The words ‘entrusts’ and ‘directs’ have been interpreted as requiring an ‘explicit and affirmative action of delegation or command’ on the part of the government. Panel Report, United States – Measures Treating Export Restraints as Subsidies, WT/DS194/R, adopted 23 August 2001, para. 8.44. Second, indirect subsidization occurs when the benefit of a subsidy is transferred or passed through from the entity that is the original recipient of the subsidy to an entity producing the products that are the subject of a countervailing duty investigation. Such transfer or pass-through takes place without the government’s explicit and affirmative action of delegation or command. See e.g., US – Lumber CVD Final, above note 5 (discussing the pass-through of subsidy benefits from the input producer to producers of downstream products that are subject to the countervailing duty investigation); and US – Lead Bars and US – CVD on EC Products, above note 11 (discussing whether a benefit originally conferred by a government subsidy to former SOEs continues to exist after the SOE was completely privatized in arm’s length transactions). See also Seung Wha Chang, ‘WTO Disciplines on Fisheries Subsidies: A Historical Step Towards Sustainability?’ 6(4) JIEL (2003) 879, at 893-894 for a discussion on indirect subsidies. 71 See US – Lumber CVD Final, above note 5, para. 143. 72 See ibid., paras. 124-146. 73 Cf. The Appellate Body has held that there is a rebuttable presumption that a benefit originally bestowed on an SOE ceases to exist after the SOE is completely privatized at arm’s length and for fair market value. See above note 12 and accompany text. 74 See Michael Daly, ‘Special Problems Concerning the Measurement of Subsidies, Annex to Investment Incentives and the Multilateral Agreement on Investment’, 32(2) J. World Trade (1998) 5, at 23-6. The fact that very few domestic subsidy cases have been filed at the WTO seems to suggest that it is difficult to prove such effects. See Chang, above note 70, at 892. It should be noted that proving adverse effects of a domestic subsidy can be easier under Article 6.1 of the SCM Agreement, which allows such effects to be assumed in four types of subsidies and shifts the burden to the subsidizing member to prove that the subsidy has not resulted any such

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the difficulty might be compounded, due to not only the lack of relevant data and statistics, but also the complex economic effects of subsidies granted in the process of market-oriented reforms. Nonetheless, it seems reasonable to expect that potential trade effects of SOE subsidies may vary depending on the purposes of such subsidies. In many cases, subsidies to loss-making SOEs merely postpone their eventual demise. Since such SOEs can hardly be competitive in international markets, the trade effects of such subsidies are likely to be limited to import displacement in the Chinese market. In other cases, loss-making SOEs may manage to revive with the help of subsidies, as shown in the example of textile SOEs discussed above, and therefore can also affect export markets.75 Subsidies provided to facilitate restructuring and privatization of SOEs, on the other hand, may have a more complex effect on trade. SOEs successfully restructured and privatized may become competitive both domestically and internationally. At the micro level, restructured or privatized SOEs may be viewed as having unfairly benefited from subsidies granted in the context of their restructuring or privatization. At the macro level, however, restructuring and privatization of SOEs reduce state ownership in the economy, which should have the effect of decreasing market distortion caused by China’s extensive state sector. In addition, subsidies so granted often have the effect of correcting historical distortion in the allocation of resources inherited from the centrally-planned system. In the long run, subsidies provided strategically to key SOEs may prove most problematic under WTO subsidy disciplines. Such subsidies are used to promote the competitiveness of a selected group of large SOEs. If this development strategy succeeds, a large group of key SOEs may emerge as major players in both domestic and international markets. Consequently, subsidies provided to such SOEs have the potential to become a constant source of disputes between China and other WTO members. As for the government bailout of state-owned banks, any resulting trade-distorting effect should be countervailable through actions against subsidies in the form of loans provided by the state banks to the producers of merchandise in question.76 As noted above, the implications of such actions may vary depending on whether the state banks are deemed part of the government or independent commercial banks under the SCM Agreement. C. What is the special challenge? In light of the foregoing discussion, what then is the special challenge that Chinese SOEs present to the WTO system? First of all, it should be clear that because China has taken a gradual approach of marketization as opposed to the ‘big bang’ approach taken by many other transition economies, it has retained and subsidized a large number of SOEs throughout the era of its economic reforms. Given the transitional nature of the Chinese economy, much of China’s subsidization of SOEs is necessitated by its economic reforms. The government has poured billions of dollars into loss-making SOEs in order to ease the political and social repercussions of massive SOE layoffs. It has also spent huge amounts to rationalize, or correct past distortions in, the allocation of resources. Restructuring SOEs through full

effect. Article 6.1, however, is subject to a provisional application of five years pursuant to Article 31 and has lapsed since the end of 1999. 75 It is doubtful, however, whether such revival can be sustained if the subsidized SOEs are not in an industry with a true comparative advantage. It seems no accident that textile SOEs should become internationally competitive in light of the fact that textile industry is a labor-intensive one where China possesses a comparative if not an absolute advantage. 76 See Section II.B.2.

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or partial privatization alone, for example, has required the government to take over the traditional responsibilities of targeted SOEs in providing the ‘cradle-to-grave’ type of social services to their employees. In dealing with the problem of non-performing loans of state banks that resulted primarily from past irrational lending to SOEs, the government has no choice but to write-off massive amounts of bad debts.

Meanwhile, reform-driven subsidies may adversely affect trade interests of other WTO

members. Products of subsidized SOEs may displace imports in the Chinese market; exports of subsidized SOEs may displace exports of third countries or products of otherwise competitive domestic producers in the importing country. Further, the government strategy to foster selected SOEs as key enterprises for the national economy is bound to collide with the interests of other WTO members in the long run.

Hence, assuming the WTO desires to encourage China to complete its transition to a market-

based economy, the special challenge presented by Chinese SOEs to the WTO system is how to balance the need of China to use subsidies in furthering its SOE reforms on the one hand, and the need to protect the trade interests of other members from adverse effects of such subsidies on the other. In addition, applying WTO disciplines to Chinese subsidies may encounter special problems in practice. For one thing, appropriate market benchmarks for identifying and measuring subsidies may not always be available due to the transitional nature of China’s economy. For another, the lack of subsidy statistics and transparency in SOE operations may render it particularly difficult to implement WTO subsidy rules in China. III. The China Protocol Provisions Regulating SOE Subsidies Pursuant to Article XII of the WTO Agreement, China acceded to the WTO on terms set out in the China Protocol on December 11, 2001. Unlike any other WTO accession thus far, the terms of China’s accession include not only market access commitments on goods and services, but also a large number of special rules that elaborate, expand, modify or deviate from the existing provisions of the WTO Agreement.77 These China-specific rules are set out in the text of the Protocol and in more than 140 paragraphs of the Report of the Working Party on the Accession of China (the Working Party Report) that are incorporated into the Protocol.78 Since the Protocol was made ‘an integral part of the WTO Agreement’,79 all the China-specific rules have become part of a ‘covered agreement’ for the purpose of the Understanding on Rules and Procedures Governing the Settlement of Disputes (DSU), enforceable through the WTO dispute settlement procedure. Among the Protocol provisions are several that directly address Chinese subsidies and SOEs. In addition, the extensive market access commitments and certain general rule commitments China has made on its economic reforms will also have a significant impact on Chinese SOEs. These terms are summarized below.

77 See Julia Ya Qin, ‘“WTO-Plus” Obligations and Their Implications for the WTO Legal System: An Appraisal of the China Accession Protocol’, 37(3) J. World Trade (2003) 483. 78 WTO, Report of the Working Party on the Accession of China, WT/MIN(01)/3, 10 November 2001. The Working Party Report (‘WPR’) has a total of 343 paragraphs. Section 1.2 of the Protocol incorporates by reference paragraph 342 of the Working Party Report, which in turn enumerates 143 separate paragraphs of the WPR. 79 Section 1.2 of the Protocol.

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A. General Obligations Affecting SOEs 1. Obligations Regarding Operations of SOEs For sound policy and legal reasons,80 the Protocol does not contain any obligation regarding privatization of SOEs in China. Rather, it requires the Chinese government to ensure that all SOEs will operate according to market economy principles. Specifically, it provides:

China would ensure that all state-owned and state-invested enterprises would make purchases and sales based solely on commercial considerations, e.g., price, quality, marketability and availability, and that the enterprises of other WTO Members would have an adequate opportunity to compete for sales to and purchases from these enterprises on non-discriminatory terms and conditions. In addition, the Government of China would not influence, directly or indirectly, commercial decisions on the part of state-owned or state-invested enterprises, including on the quantity, value or country of origin of any goods purchased or sold, except in a manner consistent with the WTO Agreement.81

This provision apparently extends the discipline of GATT Article XVII on state trading enterprises to all state-owned and state-invested enterprises in China, regardless of whether they are engaged in imports or exports. Arguably, the provision also exceeds the substantive requirements of Article XVII.82 While its effectiveness remains to be seen, the provision sets out a basic principle for the operations of China’s extensive SOE network. 2. Market Access Commitments The extensive market access commitments China has undertaken will have a far-reaching impact on its SOEs. With respect to goods, China has agreed to bind all of its tariffs, which few other countries have 80 See Section IV.A.2 for discussion on ownership-neutrality of the WTO. 81 WPR, para. 46, which was incorporated into the Protocol. 82 In light of the recent decision of the Appellate Body in Canada – Wheat, this Protocol provision seems to exceed the substantive requirements of Art. XVII:1 in at least two ways. First, the requirement that Chinese SOEs make purchases and sales ‘based solely on commercial considerations’ appears to be a stand-alone obligation, rather than being ‘dependent upon’ the obligation of non-discrimination as is the case of the requirement of ‘commercial considerations’ under Art. XVII:1(b). See above note 22. Consequently, a breach of this Protocol provision may occur if a Chinese SOE does not conduct its transaction solely based on commercial considerations, regardless of whether the SOE engages in any discriminatory practice in the transaction; in contrast, a violation of the ‘commercial consideration’ requirement of Art. XVII:1(b) can be established only if it involves a discriminatory behavior. See Appellate Body Report, Canada – Wheat, paras. 106, 110-111. Secondly, under Art. XVII:1(b) state trading enterprises are required to afford the enterprises of other members ‘adequate opportunity, in accordance with customary business practice, to compete’ for participation in their purchases and sales. While similar language appears in this Protocol provision, the phrase ‘in accordance with customary business practice’ is absent. As a result, China’s obligation to afford the enterprises of other members adequate opportunity to compete on non-discriminatory terms and conditions is not qualified by customary business practice. In addition, the obligation set out in the second sentence of the Protocol provision, i.e., that the Chinese government would not ‘influence’ directly or indirectly commercial decisions of its SOEs, seems to go beyond the somewhat similar requirement under Art. XVII:1(c). While Art. XVII:1(c) obligates a member not to ‘prevent’ any enterprise under its jurisdiction from acting in accordance with the principles of non-discrimination and commercial considerations, the Protocol provision prohibits the Chinese government from exerting any influence over commercial decisions of its SOEs regardless of whether such influence eventually ‘prevents’ the SOEs from acting in accordance with the said principles.

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done, and its commitments in the agricultural sector exceed what can be expected from most WTO members in the Doha Round.83 With respect to services, China has made commitments in all service sectors currently covered by the General Agreement on Trade in Services (GATS), and the depth of its commitments in most service areas is matched by only a handful of others.84 In addition, China has made sweeping commitments on foreign direct investment that go well beyond the existing WTO framework.85

As noted above, leveraging increased foreign competition inherited in its market access

commitments to stimulate the state sector is the raison d’etre for China’s WTO accession. Enhanced foreign competition will pressure inefficient SOEs to either go out of business or restructure into more competitive firms. In the areas where SOEs enjoy monopolistic rights, specific market access commitments will serve to break their monopoly position. A prime example is China’s commitment to completely open its state-owned banking sector to foreign financial institutions by December 2006.86 Facing this deadline, major state banks have no choice but to accelerate their reform into true commercial banks.

3. Obligation to Completely Liberalize Foreign Trade Regime Another Protocol obligation that significantly affects SOEs is that of liberalization of trading rights. Although China had already substantially decentralized its foreign trade regime before its accession – the number of firms engaged in foreign trade expanded from a dozen or so state-owned import and export companies in the early 1980’s to over 200,000 firms in the late 1990’s, including all foreign-invested enterprises in China87 – and although state trading was considered only ‘a very minor restriction on trade’ by then,88 the government still retains control over trading rights. A majority of domestic firms with such rights are state-owned;89 trading by foreign-invested firms is typically restricted to importation for their own production needs and exportation of their own products.90 Under the Protocol, China is obligated to allow ‘all enterprises in China’ to trade in all goods by December 11, 2004 except for those specified in Annex 2 of the Protocol.91 By virtue of a special national treatment clause of the Protocol, this right to trade is also extended to all foreign individuals and entities, whether invested or registered in China.92 Once implemented,93 this obligation to completely

83 See Lardy, above note 34, at 79. China has agreed to lower its average statutory tariffs on industrial products to 8.9% by 2005 and on agricultural goods to 15% by 2004. 84 Ibid., at 79-80. 85 See Qin, above note 77, at 502. 86 See above note 48. 87 See Will Martin and Christian Back, ‘The Importance of State Trading in China’s Trade Regime’, in Abbott (ed.), above note 1, 155-169. 88 Ibid., at 166. 89 Ibid., at 162. 90 See WPR, para. 80. 91 Section 5.1 of the Protocol. Annex 2A1 lists 84 products in seven categories, including grain, vegetable oil, sugar, tobacco, processed oil, chemical fertilizer and cotton, the import of which is subject to state trading. Annex 2A2 lists 134 agricultural products and commodities, such as tea, grains, metals, coal, oil, silk and cotton, the export of which is subject to state trading. Annex 2B contains a liberalization schedule covering 245 specific products. 92 Section 5.2 of the Protocol.

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liberalize trading rights will not only open more channels for imports, thus further intensifying market competition, but also finally put an end to the old state trading regime.

4. Obligation to Let Market Forces Determine all Prices A key feature of a market economy is the near absence of state intervention in price setting.94 While most price controls in China had been removed prior to its accession,95 the Protocol has now made price reforms a matter of treaty obligation. Pursuant to Section 9 of the Protocol, China is obligated to ‘allow prices for traded goods and services in every sector to be determined by market forces’ except for a few specified categories.96 This obligation represents a fundamental commitment of China to the market economy system, which is the very basis for effective application of all WTO disciplines in China, including that regarding SOE subsidies.

5. General Commitments on Subsidies – No Special Treatment

Upon accession, China became fully subject to the general WTO disciplines on subsidies. Though it is the largest developing country as well as the largest transition economy in the world, China has received little special treatment granted to such members under the SCM Agreement.97 Specifically, China has agreed:

– To eliminate all export subsidies upon accession. Section 10.3 of the Protocol requires China to eliminate all export subsidies within the scope of the SCM Agreement upon accession. Under the SCM Agreement, developing country members have at least eight years (and transition economy members seven years) from the entry into force of the WTO Agreement to phase out export subsidies.98 China’s commitment to eliminate all export subsidies upon accession

93 This Protocol obligation has been implemented by amendment to the Foreign Trade Law of China, effective 1 July 2004. See Foreign Trade Law of the People’s Republic of China, chaps. 2 and 3, available at http://english.mofcom.gov.cn. 94 Wing Thye Woo, ‘Recent Claims of China’s Economic Exceptionalism: Reflections inspired by WTO accession’, 12 China Economic Review (2001) 107, at 109. Other key features of a market economy identified by Woo include dominance of private ownership, primary reliance on capital markets to allocate investment capital, and overwhelming evenhandedness in legal treatment of state capital, domestic private capital and foreign capital. Ibid. 95 See above text at note 34. 96 Annex 4 of the Protocol lists goods and services that may still be subject to price controls. They include: (i) four categories of goods (tobacco, edible salt, natural gas and pharmaceuticals) and four categories of service sectors (public utilities, postal and telecommunication services, entrance fee for tour sites, and education services) which may remain subject to government pricing; and (ii) six categories of goods (grain, vegetable oil, processed oil, fertilizer, silkworm cocoons and cotton) and six service sectors (transport services, professional services, commission agents’ services, banking services, prices of residential apartments, and health related services) which may remain subject to government guidance pricing. In addition, China is required to make best efforts to reduce and eliminate those price controls and not to extend such controls beyond those specified in Annex 4 except in exceptional circumstances and with notification to the WTO. See Section 9 of the Protocol, and WPR, paras. 50-64. 97 The transitional nature of China’s economy was cited as the main reason for disallowing China the benefit of special treatment of developing countries under Article 27 of the SCM Agreement. See WPR, para. 171. 98 See SCM Agreement, arts. 27.2, 27.3, 27.4 and 29.

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effectively wipes out any such transitional periods that may otherwise still be available to it under the SCM Agreement.99

– Not to maintain any agricultural export subsidies. China undertook not to maintain or

introduce any export subsidies on agricultural products upon accession.100 Pursuant to the special arrangements under the Agreement on Agriculture, WTO members are not required to eliminate agricultural export subsidies, but are merely required to reduce their existing export subsidies according to certain schedules.101 Thus, the undertaking of China exceeds what is currently required of all other WTO members concerning agricultural export subsidies.

– Not to invoke developing country exceptions with respect to domestic subsidies. China

agreed not to invoke Articles 27.8, 27.9 and 27.13 of the SCM Agreement which grant special treatment to developing country members with respect to the use of domestic subsides.102 Articles 27.8 and 27.9 essentially narrow the scope of domestic subsidies used by developing country members that may be subject to action at the WTO dispute settlement forum.103 And Article 27.13 contains the privatization exception discussed above.

– No extension of the transition period for transition economy members. As noted above,

Article 29 of the SCM Agreement provides transition economy members with a seven-year transition period during which such members are given certain immunity from WTO challenges against domestic subsidies as well as export subsidies. The transition period ended December 31, 2001, shortly after China’s accession to the WTO on December 11, 2001. No extension of the transition period is provided to China.

The only special treatment that remains available to China under the SCM Agreement

concerns calculation of de minimis subsidies of developing countries, which are exempted from countervailing duties, under Articles 27.10, 27.11 and 27.12.104 Separately, regarding de minimis agricultural domestic subsidies that are exempted under the Agriculture Agreement, China has

99 China acceded to the WTO on December 11, 2001. Under the SCM Agreement, the eight-year transitional period for developing country members ends on December 31, 2002, and the seven-year transitional period for transition economies ends on December 31, 2001. 100 Section 12.1 of the Protocol; WPR, para. 234, which was incorporated into the Protocol. 101 See Agreement on Agriculture, art. 9. Specifically, developed countries agreed to reduce the value of their agricultural export subsidies by 36% within six years, and developing countries agreed to do so by 24% within ten years, from the entry into force of the WTO Agreement. For a summary of the special arrangements for agricultural products, see WTO, The Agriculture Agreement: new rules and commitments, at www.wto.org. See also generally, Jackson, above note 6, at 313-9. 102 WPR, para. 171, which was incorporated into the Protocol. 103 Article 27.8 provides an exception for developing country members from the presumption of serious prejudice regarding certain subsidies under Article 6.1. Article 6.1, however, has elapsed after a five-year provisional application in accordance with Article 31. Under Article 27.9, subsidies granted by a developing country member (other than subsidies of a certain size, those to cover operating losses of an industry or a specific enterprise, and direct forgiveness of debt) are not actionable at the WTO dispute settlement forum for causing displacement of exports of another member in a third country market, or for causing displacement of imports in the subsidizing developing country member unless the displaced imports are products covered by the tariff concessions or other obligations of the subsidizing developing country member or are otherwise found to be the result of nullification and impairment of such concessions. 104 See WPR, para. 171.

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obtained a de minimis level of 8.5% of the value of its total agricultural production during the relevant year,105 which is above the 5% de minimis level for developed country members, but below the 10% level allowed for developing country members.106 6. Notification of SOE Subsidies The Protocol requires that China notify the WTO of ‘any subsidy’ within the meaning of Article 1 of the SCM Agreement, granted or maintained in its territory, and that the information provided follow the requirements of the questionnaire on subsidies under Article 25 of the SCM Agreement.107 The first such notification was attached to the Protocol as Annex 5, which identifies more than 20 categories of government subsidies, including budgetary funding to certain loss-making SOEs, loans from the state policy banks, tax benefits and other preferential treatment granted to foreign-invested enterprises, high tech enterprises, enterprises transferring technologies, enterprises in certain specific industries and enterprises located in special economic zones, and provision of low-price inputs from special industrial sectors.108 In addition, the notification lists three categories of subsidies to be phased out by 2000, including budgetary funding from the central government to certain loss-making SOEs, and export subsidies to automobile and motorcycle industries.109

Regarding SOE subsidies, the notification discloses the amounts of annual budgetary funding from the Chinese central government to SOEs in nine particular industries, and that from 31 local governments to loss-making SOEs, for the period of 1990-1998.110 The notification, however, is not comprehensive. Among other things, it does not identify subsidies provided to SOEs through the state-owned banks, such as policy loans, automatic rollover of unpaid principal and interest, forgiven loans and below-market low-interest loans. Citing difficulties involved in gathering information, China undertakes that it will ‘progressively work towards a full notification of subsidies, as contemplated by Article 25 of the SCM Agreement.’111

The Protocol also requires China to notify under the Transitional Review Mechanism112 ‘fiscal

and other transfers between or among state-owned enterprises in the agricultural sector (whether national or sub-national) and other enterprises that operate as state trading enterprises in the agricultural sector.’113 This requirement reflects the concern of other members that transfers among SOEs may result in agricultural subsidies inconsistent with China’s commitments under the Protocol, particularly the commitment to eliminate all export subsidies on agricultural products upon accession.114 105 WPR, para. 235, which was incorporated into the Protocol. 106 See Agreement on Agriculture, art. 6.4. 107 Section 10.1 of the Protocol. 108 See Annex 5A of the Protocol. 109 Annex 5B of the Protocol 110 Annex 5A of the Protocol, Sections I and II. 111 WPR, para. 173, which was incorporated into the Protocol. 112 See Section 18 of the Protocol. Under the Transitional Review Mechanism, China is subject to annual review of its implementation of WTO obligations during the first eight years of its accession, and a final review in the tenth year or an earlier date to be decided by the General Council. 113 Section 12.2 of the Protocol. 114 See WPR, para. 233 (‘Some members of the Working Party expressed concern that large stocks in China of grain and cotton had been procured at relatively high prices by state-trading enterprises or other state-affiliated,

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Given the inherent lack of transparency in SOE operations, China’s compliance with these

notification requirements is of particular importance for the effective application of WTO subsidy disciplines in China. B. The SOE-Based Specificity Test In addition to the general obligations relevant to SOE subsidies described above, the Protocol contains a provision that directly targets subsidization of SOEs in China. Section 10.2 of the Protocol reads:

For purposes of applying Articles 1.2 and 2 of the SCM Agreement, subsidies provided to state-owned enterprises will be viewed as specific if, inter alia, state-owned enterprises are the predominant recipients of such subsidies or state-owned enterprises receive disproportionately large amounts of such subsidies.

In accordance with Article 1.2 of the SCM Agreement, a domestic subsidy is actionable only

if it is specific within the meaning of Article 2.115 Under Article 2, a subsidy is specific if it is granted to ‘an enterprise or industry or group of enterprises or industries’ (referred to as ‘certain enterprises’). To determine whether a subsidy is specific, Article 2.1 set forth three guidelines:

(a) A subsidy is specific if the granting authority explicitly limits access to the subsidy to certain enterprises (de jure specific). (b) A subsidy is not specific if there are objective criteria or conditions governing the eligibility for, and the amount of, the subsidy which are clearly spelled out in official document so as to be capable of verification (de jure non-specific).116 (c) Despite its appearance of non-specificity, a subsidy may be found in fact to be specific (de facto specific). In determining de facto specificity, several factors may be considered: (i) the use of subsidy by a limited number of certain enterprises, (ii) predominant use by certain enterprises, (iii) the granting of disproportionately large amounts to certain enterprises, and (iv) the manner in which discretion has been exercised by the government in granting the subsidy. In addition, account shall be taken of the extent of diversification of economic activities within the jurisdiction of the granting authority, as well as of the length of time during which the subsidy program has been in operation.

Further, a subsidy is specific if it is limited to certain enterprises located within a designated geographical region.117

state-run, or state-controlled entities and noted that exports of these or other government-purchased products at prices lower than the comparable price charged for the like product to buyers in the domestic market could be challenged as an export subsidy or as inconsistent with other WTO obligations. ... In response, ... the representative of China stated that national and sub-national authorities would not provide fund transfers or other benefits to any entities in China that would be inconsistent with its WTO obligations, including to offset losses accrued through exports.’) 115 In accordance with Article 2.3, all export subsidies are deemed to be specific. 116 ‘Objective criteria or conditions’ are defined as those that are neutral, do no favor certain enterprises over others, and are economic in nature and horizontal in application, such as number of employees or size of enterprise. See SCM Agreement, footnote 2. 117 SCM Agreement, art. 2.2. Further, any determination of specificity ‘shall be clearly substantiated on the basis of positive evidence.’ SCM Agreement, art. 2.4.

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Under these guidelines, a critical issue is how to define a ‘group’ of enterprises or industries as

‘certain enterprises’ in a given situation. The SCM Agreement is silent on the issue. Consequently, whether the recipients of a particular subsidy constitute a ‘group’ becomes a matter of interpretation on a case-by-case basis. So far the issue has arisen in only two WTO cases.118 And it remains unclear whether there should be certain criteria or standards for defining a group of enterprises or industries, and if so, what they should be.119

Significantly, the Protocol now sets forth a special criterion for defining a ‘group’ in the case of a Chinese subsidy: state ownership. According to Section 10.2, a Chinese subsidy ‘will be viewed’ as specific if, among other (unspecified) things, one of the two conditions exists: (a) SOEs are the ‘predominant recipients’ of the subsidy, or (b) SOEs receive ‘disproportionately large amounts’ of the subsidy. While these two conditions appear to be similar to two of the four factors listed in Article 2.1(c) that ‘may be considered’ in determining de facto specificity of a subsidy,120 the existence of either one condition will suffice for finding de facto specificity of a Chinese subsidy. The term ‘state-owned enterprises’ is not defined in the Protocol, but it may be reasonably understood as including both state-owned and state-controlled enterprises.

The potential effect of this new criterion can be illustrated by the following hypothetical case.

Suppose the government maintains a program that reduces taxes proportionately on any enterprise that employs a certain percentage of its work force from registered laid-off workers each year; and numerous enterprises in a variety of industries have participated in the program. Normally, the

118 In US–Lumber CVD Final, Canada challenged the U.S. countervailing duty determination that the Canadian stumpage programs are used only by ‘a limited group of wood product industries’ and therefore are de facto specific. The Panel held the U.S. determination is ‘not inconsistent’ with Article 2, finding that the ‘wood products industries’ constitute ‘at most only a limited group of industries’ under any definition of the term ‘limited.’ Panel Report, WT/DS257/R, 29 August 2003, para. 7.121. The Panel report was partially reversed by the Appellate Body, above note 5, but the Panel’s finding on the issue of specificity was not appealed. In United States – Continued Dumping and Subsidy Offset Act of 2000 (‘U.S.– Byrd Amendments’), Panel Report, WT/DS217, 234/R, Appellate Body Report, WT/DS217, 234/AB/R, adopted 27 January 2003, Mexico claimed that the U.S. program of disbursing antidumping and countervailing duties to petitioners and supporters of antidumping and countervailing duty findings and orders constituted an actionable subsidy based on de jure specificity. The panel, however, did not decide whether the potential beneficiaries of the program can be considered a group under Article 2.1 on the ground that Mexico had failed to claim the program per se, rather than disbursements under the program, is de jure specific. 119 In the United States, in determining whether a subsidy is being provided to a ‘group’ of enterprises or industries, Department of Commerce is not required to determine whether there are shared characteristic among the enterprises or industries that are eligible for or actually receive a subsidy. 19 C.F.R. §351.502(b). Meanwhile, Commerce will not regard a subsidy as specific solely because the subsidy is limited to the agricultural sector or to small firms or small-and medium-sized firms. 19 C.F.R. §351.502(d) and (e). See also US Department of Commerce, Notice of Final Countervailing Duty Regulations, 63 Fed. Reg. 65348 (25 November 1998) for explanation of the rules. Commerce holds the view that the specificity test is to be used as ‘an initial screening mechanism to winnow out only those foreign subsidies which truly are broadly available and widely used throughout an economy.’ See NAFTA Binational Panel Review, In the Matter of Certain Softwood Lumber Products from Canada, Final Affirmative Countervailing Duty Determination, Panel No. USA-CDA-2002-1904-03 (13 August 2003), 2003 FTAPD LEXIS 8, at 76. 120 The Panel in US – Lumber CVD Final rejected Canada’s argument that an investigating authority is required to examine all four factors listed in Article 2.1(c), noting that the use of the verb ‘may’ rather than ‘shall’ indicates that an authority may look at any of the four factors in determining specificity. Panel Report, US – Lumber CVD Final, above note 118, para. 7.123.

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program should be de jure non-specific under Article 2.1(b) of the SCM Agreement since it was made broadly available to any enterprise meeting a certain objective criterion. If there are reasons to believe that the program is in fact specific, the four factors identified in Article 2.1(c) may be considered. In the case of a Chinese subsidy, however, a separate inquiry would be made into the ownership of the recipients pursuant to the Protocol. If most of the recipients happen to be state-owned, the program will be viewed automatically as de facto specific.

C. Non-Market Economy Methodologies for Calculating Chinese Subsidies Under the SCM Agreement, to determine whether a financial contribution by the government has conferred a benefit on the recipient, the guidelines set forth in Article 14, Calculation of the Amount of A Subsidy in Terms of the Benefit to the Recipient, shall apply.121 These guidelines address government equity investment, loans, loan guarantees, provision of goods or services and purchase of goods by the government. According to the Appellate Body, ‘[a] “benefit” arises under each of the guidelines if the recipient has received a “financial contribution” on terms more favorable than those available to the recipient in the market.’122 Except in the case of loans and loan guarantees, Article 14 explicitly defines the relevant market conditions for comparison as those prevailing in the territory of the subsidizing Member.123

The Protocol authorizes a departure from the guidelines of Article 14 in the case of China.

Section 15(b) of the Protocol provides: In proceedings under Parts II, III and V of the SCM Agreement, when addressing subsidies described in Articles 14(a), 14(b), 14(c) and 14(d), relevant provisions of the SCM Agreement shall apply; however, if there are special difficulties in that application, the importing WTO Member may then use methodologies for identifying and measuring the subsidy benefit which take into account the possibility that prevailing terms and conditions in China may not always be available as appropriate benchmarks. In applying such methodologies, where practicable, the importing WTO Member should adjust such prevailing terms and conditions before considering the use of terms and conditions prevailing outside China. (emphasis added)

This provision appears to loosely follow the pattern of GATT Ad Article VI noted above,

which recognizes that in applying the antidumping provisions of GATT Article VI to a non-market economy, ‘special difficulties’ may exist in determining price comparability and that the importing member may find it necessary ‘to take into account the possibility that a strict comparison with

121 ‘Although the opening words of Article 14 states that the guidelines it establishes apply “for the purposes of Part V” of the SCM Agreement, which relates to “countervailing measures”, our view is that Article 14, nonetheless, constitutes relevant context for the interpretation of “benefit” in Article 1.1(b). The guidelines set forth in Article 14 apply to the calculation of the “benefit to the recipient conferred pursuant to paragraph 1 of Article 1”’. Appellate Body Report, Canada –Aircraft, above note 10, para. 155. 122 Appellate Body Report, Canada –Aircraft, ibid., para. 158. 123 See Article 14(a), (b), (c) and (d). For government provision of equity capital, the proper benchmark is ‘the usual investment practice (including for the provision of risk capital) of private investors in the territory of that Member.’ For a loan or loan guarantee by a government, it is ‘a comparable commercial loan’ which the recipient ‘could actually obtain on the market’ absent the government guarantee. For the provision of goods or services or purchase of goods by a government, the benchmark is ‘prevailing market conditions for the good or service in question in the country of provision or purchase (including price, quality, availability, marketability, transportation and other conditions of purchase or sale).’

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domestic prices in such a country may not always be appropriate.’124 The Protocol now extends the logic of Ad Article VI to WTO subsidy disciplines.125

Significantly, Section 15(b) is the first and only WTO provision that explicitly authorizes the

use of alternative benchmarks, i.e., the so-called non-market economy methodologies, in calculating the amount of a subsidy granted by a transition economy. Such methodologies may be used to determine Chinese subsidies not only in countervailing duty actions, but also in WTO proceedings taken under Part II or III of the SCM Agreement. This provision applies to all Chinese subsidies including those to SOEs.

IV. Evaluation As shown in Section III, the Protocol regulation of SOE subsidies has several components. First, it sets forth certain general obligations ensuring the existence of market economy conditions in China, including obligations regarding autonomous operations of SOEs. Second, it requires China not to seek special treatment granted to developing country members under the SCM Agreement, including that for subsidies used in the context of privatization. Third, it provides two special remedy rules: (a) an SOE-based specificity test and (b) NME methodologies for calculating Chinese subsidies. In addition, the Protocol contains no exception for the use of subsidies necessary for China’s transition to a market-based economy.

This Section evaluates the approach of the Protocol in view of the special challenges presented

by China’s SOEs to the WTO system. It contends that, except for the general obligations concerning market economy conditions, the Protocol approach may be seen as misguided at best, and at worst fundamentally flawed. That is so because the Protocol, on the one hand, fails to take into account any need China might have to use subsidies to carry out privatization and other market-oriented reforms, and on the other, creates special remedy rules that do not adequately address the special problems inherent in subsidization of SOEs. Furthermore, these rules are problematic in light of WTO norms and disciplines. As a result, the Protocol may have negative implications not only for economic reform in China but also for the WTO legal system.

A. The SOE-Based Specificity Test The SOE-based specificity test is the core provision of the Protocol addressing subsidization of SOEs in China. It is also the only WTO provision that targets state ownership for trade remedies. The justification for this unique provision, however, remains unclear. 1. The Issue of Rationale

The specificity provision of the SCM Agreement ‘is concerned with the distortion that is created by a subsidy which either in law or in fact is not broadly available.’126 Originating in U.S. countervailing duty law, the concept of specificity reflects an economic rationale that a subsidy that is made broadly available to the society can have only minimal distorting effects on international trade.127 However, it

124 Above discussion at note 30. 125 See above note 31 and accompanying text. 126 Panel Report, US – Lumber CVD Final, above note 118, para. 7.116. 127 See Jackson, above note 6, at 296-7. Jackson points out that the economic arguments can only go part of the way toward explaining a rationale for the specificity test. Another part of the rationale for the test is that it offers

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is uncertain how broadly available a subsidy must be in the economy in order to be free of such distorting effects.128

The lack of clarity in the economic rationale may be partially responsible for the vagueness of

the specificity test in Article 2 of the SCM Agreement. Without any specific standard or criterion set out in the Agreement, however, the issue of what constitutes ‘broad availability’ of a subsidy can only be determined using criteria or standards supplied by individual importing members in countervailing cases,129 and by a WTO panel and the Appellate Body in cases brought to the WTO dispute settlement forum.

Nonetheless, it is still useful to consider in the abstract whether, based on the economic

rationale of the test, specificity might be established on the basis of state ownership in China. Suppose the Chinese authority ‘expressly limits the access’ to a subsidy program to state-owned firms, could the program be viewed as de jure specific under Article 2.1(a)? If we assume ‘broad availability’ implies a numerical standard of at least a majority of the enterprises in an economy, then the program would be de jure specific since SOEs no longer constitute a majority of all enterprises in China. That assumption, however, remains untested under WTO law.130 The case would become even less clear if the subsidy is made legally available to any enterprise in China meeting certain objective criteria for eligibility, i.e., de jure non-specific under Article 2.1(b), but in fact benefits SOEs more than private enterprises. Considering that China still has a massive number of SOEs that are widely distributed across many industries in the economy, the chance of finding such subsidies could be substantial. The hypothetical case given above regarding a tax incentive granted to firms that employ laid-off workers illustrates such a situation.131 Since most (if not all) subsidies would have only a limited number of actual beneficiaries, it would render Article 2.1(b) (de jure non-specificity) meaningless if all such subsidies could be deemed de facto specific under Article 2.1(c). In short, given the special nature of

a useful tool for the administration (albeit sometimes blunt) of countervailing measures. Since all governments engage in general activities that can confer a benefit on the production of internationally traded goods, it is necessary in practice to exclude such activities from the realm of countervailing actions. See also Michael J. Trebilcock & Robert Howse, The Regulation of International Trade, 2nd ed. (Routledge, 1999), at 207-8 (describing the evolution of the specificity test in the United States). 128 See Rambod Behboodi, Industrial Subsidies and Frictions in world Trade: trade policy or trade politics? (Routledge, 1994), at 138 (pointing out that there is a problem in the economic logic of the specificity test in that, while a subsidy generally available in a small country is non-specific, a subsidy provided to a region by a large country would be caught by the specificity test). 129 The EC has been criticized for having interpreted the concept of specificity in such a manner that under its criteria any tax law would be loaded with specific subsidies. See Paul Waer & Edwin Vermulst, ‘EC Anti-Subsidy Law and Practice After the Uruguay Round: A Wolf in Sheep’s Clothing?’ 33(3) J. World Trade (1999) 19, at 42. 130 In U.S.–Byrd Amendments, above note 118, a potential issue was whether the U.S. program to disburse antidumping and countervailing duties to any domestic producers that are petitioners or supporters of antidumping or countervailing duty orders is a de jure specific subsidy because the program expressly limits recipients of disbursement to such firms. The U.S. argued that the program is not specific because the universe of potential recipients is far too large and varied to be considered a ‘group’. This argument apparently is not based on a specific numerical standard since it is unlikely that a majority of enterprises in the U.S. would be involved in antidumping or countervailing cases. The U.S. argument, however, was unaddressed by the Panel because Mexico did not claim de jure specificity of the program itself, and instead claimed specificity of each disbursement of the program, which was rejected by the Panel. See Panel Report, WT/DS217, 234/R, paras. 7.110-7.115. 131 See the last paragraph of Section III.B above.

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the Chinese economy – numerous SOEs coexisting with non-state enterprises and widely distributed across many industries132 – it is doubtful that specificity can be established solely on the basis of state-ownership of enterprises in China under the ‘broadly available’ rationale.

Ultimately, the question remains whether state ownership should be used as a special criterion

for identifying a ‘group’ of enterprises under Article 2. The Protocol has answered this question in the affirmative. But what is its rationale? Neither the Protocol nor the Working Party Report provides an explanation.

– Are China’s subsidies to SOEs inherently more trade-distorting? By making China’s subsidies to SOEs automatically specific, the Protocol apparently assumes

that such subsidies are particularly damaging to trade. The notion that subsidization of SOEs has more trade-distorting effects than that of private enterprises, however, lacks support in economic logic. To the extent a subsidy has a trade-distorting effect,133 it is the subsidy itself, not the status of the recipient, that causes such effect. For example, an interest-free loan provided by the government can lower the financing cost for the borrower, regardless whether the borrower is privately or publicly owned. In reality, the actual economic benefit of the loan to the borrower may depend on how effectively the borrower can utilize the loan. Given that SOEs are normally less efficient than private enterprises, it is possible that the same subsidy provided to an SOE would actually produce less economic benefit, and correspondingly less trade effect, than that to a private enterprise.

It has been observed that subsidization of SOEs may cause more adverse effects on trade in a market downturn, because a subsidized SOE, which may be used by government to achieve policy objectives other than profit maximization, can sustain operations much longer than a private firm, which must consider whether it can afford to continue operations over an extended period.134 As a result of prolonged subsidization of SOEs, the market can become further depressed, ultimately driving competing private firms out of business. This observation, however, does not compare the

132 It might be reasonable to take into account the special nature of an economy in determining whether a particular subsidy is broadly available. A similar idea is embodied in the provision of Article 2.1(c) requiring that for purposes of determining de facto specificity ‘account shall be taken of the extent of diversification of economic activities within the jurisdiction of the granting authority’. This provision is understood to refer to single-industry economies where a subsidy made to one dominant industry is in fact made broadly available to most of the enterprises in the economy. See Chang, above note 70, at 900-1. See also, Panel Report in US– Lumber CVD Final, above note 118, para. 7.124. 133 It is generally accepted that domestic subsidies can also have the effect of correcting market distortions. While there is a general consensus on the trade-distorting effect of export subsidies, no such consensus seems to exist concerning the trade effects of domestic subsidies. See generally, Trebilcock & Howse, above note 127, at 190 (pointing out that while in the United States subsidies are often viewed as illegitimate distortion of international trade, in other countries they have often been considered a legitimate instrument of domestic policy); Jacques H. J. Bourgeois, ‘The GATT Rules for Industrial Subsidies and Countervailing Duties and the New GATT Round – The Weather and the Seeds’, in Petersmann & Hilf (eds), The New GATT Round of Multilateral Trade Negotiations: Legal and Economic Problems (Kluwer, 1991) 219, at 231-2 (describing two schools of thought on the purposes of regulating subsidies). 134 Marc Benitah, The Law of Subsidies under the GATT/WTO System (Kluwer Law International, 2001) at 78 (describing special adverse effects caused by state trading enterprises, based on a study by K.R. Button, ‘Subsidization of State Trading Enterprises Production of Mineral Products: An Assessment of Possible Revisions to the GATT Articles and Subsidies Code in the Uruguay Round of Trade Negotiations’, 15 N. Carolina J. of Int’l Law and Commerce Reg. (1990) 337).

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effect of a government subsidy to an SOE with the same provided to a private enterprise. Rather, it compares government subsidies with private subsidies.135 Assuming a government has deeper pockets than most private shareholders, government financing can outlast that of private shareholders in a market downturn. But there is no reason to assume that a government can subsidize only SOEs for its policy objectives.136 A private firm subsidized by the government may find it just as economically viable to sustain in a down market for as long as the subsidy lasts.

One might contend, however, that even if subsidization of SOEs is not inherently more trade-

distorting, China’s subsidies to SOEs could be particularly damaging to trade because of their enormous scale. According to one study, the GDP percentage of total subsidies to SOEs in 1985-1994 ranged from the highest level of 10.2% in 1987 to lowest 3.9% in 1994, showing a steady decline over the period.137 Based on China’s first notification of subsidies to the WTO, budgetary payments to certain loss-making SOEs in 1995-1998 were about 0.4-0.5% of the GDP in the corresponding years.138 The notified amounts do not include budgetary payments to other SOEs nor bank loans. Although comprehensive statistics on China’s subsidization of SOEs are unavailable, the size of historical SOE subsidies does not seem to be particularly large in terms of their GDP share. For instance, according to the Organization for Economic Cooperation and Development (OECD), agricultural subsidies alone accounted for 2.3% of the GDP in the OECD area in 1986-1988, and 1.2% in 2001 and 2002.139 Also, industrial subsidization in G7 countries exceeded 2% of GDP in the mid 1980’s.140 In terms of absolute amounts, given the size of the Chinese economy, any general subsidy is likely to be substantial regardless of whether it is provided to SOEs. Therefore, the trade effects of a subsidy can only be determined based on the specific facts of the case.

135 For a comparison between the effects of public subsidies and that of private subsidies and the suggestion on regulation of private subsidies, see Charles O. Verrill, Jr., ‘State Owned Enterprises and the Countervailing duty Law: Where, Oh, Where to Draw the Line’, in Wallace, Loftus, Krikorian (eds.), Interface Three: Legal Treatment of Domestic Subsidies (International Law Institute, 1984), at 35. 136 At least one commentator has questioned the wisdom of maintaining a distinction between private and state enterprises under GATT rules. According to him, the distinction is based on the assumption that private firms can only be influenced by general rules (public, known in advance) whereas state firms can also be directed through specific measures (secret, verifiable only ex post). When the government subsidizes a private firm, it acquires power to direct the operation of the firm through specific measures. Hence, in today’s world where governments commonly subsidize private firms, the original distinction between a private firm and a state firm has lost its original significance. See Roessler, above note 24, at 262 and 281. 137 Justin Yifu Lin, ‘WTO Accession and China’s SOE Reform’, in Kyung Tae Lee, Justin Yifu Lin & Si Joong Kim (eds.), China’s Integration with the World Economy: Repercussions of China’s Accession to the WTO (Korea Institute for International Economic Policy, 2001), 55, at 60, Table 2 (Subsidies to SOEs: Sources and Percentage of GDP). 138 See above text at note 52 for the amounts of budgetary payment to certain loss-making SOEs in 1995-98. China’s GDP was RMB5,847, 6,859 billion, 7,446 billion and 7,834 billion in the corresponding years. Source: US-China Business Council, China Statistics and Analysis, available at www.uschina.org. 139 Organization for Economic Co-operation and Development, Agricultural Policies in OECD Countries: Monitoring and Evaluation 2003 – Highlights (3 June 2003), p. 5, available at www.oecd.org. The OECD statistics have been controversial. See BNA, WTO Reporter, ‘Lamy Blasts WTO’s Supachia over ‘Extremely Misleading” Ag Subsidy Claims’ (24 March 2004); ‘OECD Defends Subsidy Calculations Contested by Lamy in WTO Farm Talks’ (14 April 2004). Available at www.bna.com. 140 See Trebilcock & Howse, above note 127, at 190.

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In addition, it should not be forgotten that part of the SOE subsidies during the reform era has been provided to correct misallocation of resources resulting from the centrally-planned system. Such subsidies should have the effect of correcting market distortions rather than creating new ones. – A compensation for the lack of transparency?

One might further contend that subsidization of SOEs in China warrants a special scrutiny because the lack of transparency in the Chinese system makes it difficult to discipline subsidies to a massive number of SOEs. Undoubtedly, the lack of transparency in the operations of SOEs poses a special challenge to the regulation of Chinese subsidies. Aside from the lack of statistics, subsidies to SOEs, especially those channeled through local governments and state-owned financial institutions, are difficult to identify and monitor. Although China is required to notify the WTO of any subsidy granted or maintained within its territory and did submit its first notification upon accession, it has since failed to provide any further subsidy notification as required.141

The problem of transparency, however, cannot be solved by making SOE subsidies

automatically ‘specific’ under the SCM Agreement. In order to be actionable, a subsidy must fall within the definition of subsidy under Article 1 of the SCM Agreement. According to Article 1, a subsidy is a government ‘financial contribution’ that confers a ‘benefit’ on the recipient. If one cannot identify whether the government has made a financial contribution to SOEs or the amount of such contribution due to lack of information, one simply cannot determine whether a benefit has been conferred to SOEs and therefore that a subsidy within the meaning of Article 1 exists. Thus, to ensure that WTO subsidy disciplines can be effectively applied to subsidization of SOEs, there must be an adequate level of disclosure. To that end, it would be desirable if the Protocol explicitly required a separate disclosure of SOE subsidies.142 A more difficult problem, however, lies in the lack of effective means for the WTO to enforce its notification requirements. In practice, a majority of WTO members have not fully complied with the notification requirements under Article 25 of the SCM Agreement, and many have simply failed to submit any notification.143 It is therefore not surprising that China cited the delay of notifications by other WTO members as an excuse for its own non-compliance.144 The issue of enforceability of the notification obligation requires solutions at a systemic level of the WTO. – A policy incentive for privatization? 141 In fact, China’s failure to comply with the notification requirements became a focal point during the second annual review of China’s WTO compliance under the Transitional Review Mechanism. See WTO Committee on Subsidies and Countervailing Measures, Chairman’s Report to Council for Trade in Goods on Transitional Review of China, G/SCM/111, 4 November 2003. The reasons for such failure cited by the Chinese representative include partial understanding of the WTO notification requirements by local officials, under-performance of the domestic information collection system and varied criteria on statistics. Ibid., at p. 4. 142 The Protocol requires the Chinese government to notify the WTO of ‘any subsidy’ granted or maintained in China, but does not explicitly require a separate notification of SOE subsidies. See above Section III.A.6. 143 For example, pursuant to Article 25 of the SCM Agreement all members were required to submit a new and full notification to the Committee by June 30, 2001. As of October 31, 2001, only 39 members (with EU counted as one member) submitted such notification and 15 members notified they maintained no notifiable subsidies. See WTO, Report (2002) of the Committee on Subsidies and Countervailing Measures, G/L/585, 6 November 2002, p. 2. 144 See WTO Committee on Subsidies and Countervailing Measures, Chairman’s Report to Council for Trade in Goods on Transitional Review of China, G/SCM/49, 18 November 2002, p.6.

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One might also reason that the SOE-based specificity test can serve as an incentive for the Chinese government to privatize its economy. Presumably, the fewer SOEs that remain, the less useful the test would be. While it is true that China could enhance its economic welfare with a smaller state-owned sector, to claim that the SOE-based specificity test can help China to achieve that objective would be disingenuous. Whether and how China will privatize its state sector is a matter of its national economic policy, and it would be naive to believe such policy will be driven by potential litigation at the WTO or countervailing action of its trading partners. Moreover, the SOE-based specificity test aims at any and all subsidies to SOEs and can be applied against many that are provided for the purposes of restructuring and privatizing SOEs.145 Consequently, the SOE-based specificity test might well be counterproductive for China’s SOE reform. 2. A Curious Departure from the WTO Philosophy The provision of the SOE-based specificity test also departs from the ownership-neutral philosophy of the world trade system. While WTO rules are based upon market economy assumptions and private enterprises are the hallmark of a market economy, the WTO does not prescribe any particular economic system for its members and its obligations are unconcerned with the ownership of traders.

The ownership-neutral position of the world trade system can be understood on several

grounds. First of all, this position is legally consistent with the requirements of international law. It is a basic principle of international law that each state has the right to freely choose its own political, social and economic system,146 and property ownership is at the heart of such system. Accordingly, WTO law should not take sides in prescribing basic choices in organizing the economy of its members, and it should remain neutral regarding the formation and ownership of capital, whether private or public.147 In practice, the world trade system has never excluded economies that are completely owned and controlled by the state despite its lack of an effective means to integrate them fully.148

The ownership-neutral philosophy of the WTO can also be understood from a historical

perspective. The 20th century witnessed a growing economic importance of the state in many nations. Among the historical factors contributing to this phenomenon are socialist movements following the 145 See Section II.B.1(b) above. 146 See Declaration on Principles of International Law Concerning Friendly Relations and Co-Operation among States in accordance with the Charter of the United Nations, adopted by United Nations General Assembly Resolution 2625 (XXV) as of 24 October 1970. 147 Thomas Cottier & Petros Mavoidis, ‘Conclusions: The Reach of International trade Law’, in Cottier & Mavroidis (eds.), above note 19, 395, at 397. 148 Two original contracting parties to the GATT, Czechoslovakia and Cuba, retained their status within the system despite their subsequent adoption of centrally-planned economies. After the establishment of the WTO, the Czech Republic and Slovakia, as the successors of former Czechoslovakia, and Cuba all became original WTO members. Four other countries, Yugoslavia, Poland, Romania and Hungary, acceded to the GATT while practicing their centrally-planned economic regimes. To accommodate the differences between the two systems, the accession protocols of Poland, Romania and Hungary each contained certain special provisions, including specific import commitments in the case of Poland and Romania, and the right of contracting parties to impose special safeguards on the imports from all three countries. None of these special provisions referred to the state ownership of these economies. See generally, M. M. Kostecki, East-West Trade and the GATT System (St. Martin’s Press, 1979).

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Russian Revolution of 1917, the Great Depression of the 1930’s, the end of colonialism and the quest of developing nations for industrialization in the latter part of the century.149 Apart from growing government spending and regulation of economies, nations also established SOEs as tool for achieving objectives of government policies and many among them, especially developing countries, relied on SOEs to provide goods and services vital for their economies.150 Although the trend appears to have been reversed in the direction of privatization in the past decade, due to the collapse of the Soviet model and an increasing recognition that SOEs are typically less efficient than private enterprises, there still exist among nations divergent views as to the proper role of the government and state-owned sectors in the economy. As the World Bank pointed out, finding the right mix of public and private ownership in an economy continues to be a major challenge for many countries.151

Perhaps more important to the understanding of the ownership-neutral position of the world

trade system is its underlying economic rationale. Theoretically, what concerns the WTO system is not the ownership of traders, but the market structure in which traders operate.152 The main function and purposes of the world trading system are to reduce barriers or obstacles enacted or sanctioned by governments that distort markets and flow of trade.153 While governments may interfere with markets by instructing SOEs to act in a manner inconsistent with commercial considerations, SOEs cannot define the terms of trade unless they are also granted monopoly or exclusive rights.154 As various authors have indicated, what matters to the world trading system is not ownership, but the exclusive or monopoly rights granted to firms by the government allowing non-competitive behavior.155

This understanding is reflected in WTO provisions. With respect to trade in goods, GATT

Articles II:4 and XVII set out the basic disciplines on state trading firms,156 but neither provision refers to the ownership of such entities. Although state-owned enterprises are undoubtedly covered by these provisions, the disciplines of these provisions also reach private firms that have been given monopolistic rights or exclusive or special privileges. Interestingly, the term ‘state trading enterprises’ is not defined in GATT. However, a working definition of the term was developed during the Uruguay

149 See The World Bank Group, Beyond Economic Growth: Meeting the Challenges of Global Development (2000), chap. 11 ‘Public and Private Enterprises: Finding the Right Mix’. 150 For country data on SOE’s share of GDP and gross domestic investment (GDI) 1986-91, see The World Bank Group, ibid., Table 3. The SOE share of GDP and GDI tends to be higher in poorer countries. In comparison, developed countries rely on government spending more than SOEs to intervene in their economies. Ibid., Figures 11.1 and 11.2. 151 Ibid. 152 See Aaditya Mattoo, ‘Dealing with Monopolies and State Enterprises: WTO Rules for Goods and Services’, in Cottier & Mavroidis (eds.), above note 19, at 38. 153 The Uruguay Round has expanded the traditional type of ‘negative regulation’ under the GATT to the kind of ‘positive regulation’ as embodied in the TRIPs. 154 See Ernst-Ulrich Petersmann, ‘GATT Law on State Trading Enterprises: Critical Evaluation of Article XVII and Proposals for Reform’, in Cottier & Mavroidis (eds.), above note 19, at 80; and Diane P. Wood, ‘State Trading in the United States’, ibid., at 212. 155 Bernard M. Hoekman & Patrick Low, ‘State Trading: Rule Making Alternatives for Entities with Exclusive Rights’, in Cottier & Mavroidis (eds.), above note 19, 327, at 329; Martin & Back, above note 87, at 156, citing B. Hoekman & M. Kostecki, The Political Economy of the World Trading System: from GATT to WTO (Oxford University Press, 1995). 156 Article II:4 requires that a state-authorized import monopoly (whether owned by the state) shall not charge excessive margins and shall ensure the satisfaction of domestic demands for imports. See GATT Ad Article II, paragraph 4 (referring to Article 31 of the Havana Charter). See Section I.C for discussion on Article XVII.

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Round for the purpose of notifying such enterprises to the WTO. According to the Understanding on the Interpretation of Article XVII of the General Agreement on Tariffs and Trade 1994 (Understanding), WTO members are required to notify to the Council for Trade in Goods:

Governmental and non-governmental enterprises, including marketing boards, which have been granted exclusive or special rights or privileges, including statutory or constitutional powers, in the exercise of which they influence through their purchases or sales the level or direction of imports or exports.157

Significantly, this definition, on the one hand, covers all non-state enterprises that have been granted exclusive or special rights or privileges and can influence, in the exercise of which rights or privileges, the level or direction of trade. On the other, it excludes all state-owned or controlled enterprises that have not been granted such rights or privileges and do not possess such ability to influence trade.158

The concept of state enterprises does not appear in other WTO agreements. Although the SCM

Agreement, through Article 27.13, expresses a preference for privatization in developing countries, it does not impose any obligation regarding state enterprises.159 With respect to trade in services, the General Agreement on Trade in Services (GATS) addresses behavior of monopolies and exclusive service providers, but makes no reference to their ownership.160 The absence of reference to state enterprises in GATS and the narrow definition of state trading enterprises in the Understanding reflect a market structure-based view as opposed to an ownership-based view.161

The ownership-neutral position of the WTO has been observed in the accession of all other transition economies thus far. While these countries typically carried out large-scale privatization programs, some of them still had substantial state sectors at the time of accession.162 None of the protocols of accession of these countries, however, contains an obligation to privatize SOEs. The only relevant requirement for these countries was to continue to provide information on the status of their on-going privatization programs.163

157 See Section 1 of the Understanding on the Interpretation of Article XVII of the General Agreement on Tariffs and Trade 1994. 158 It should be noted that the Preamble of the Understanding states that ‘this Understanding is without prejudice to the substantive disciplines prescribed in Article XVII’. For a critical evaluation of the Understanding, see Petersmann, above note 154. 159 See Section I.B.1 above. It is also interesting to note that Article 29.1 of the SCM Agreement defines a transition economy as one ‘in the process of transformation from a centrally-planned into a market, free-enterprise economy’, which avoids a reference to either state or private ownership. 160 See GATS Art. VIII, Monopolies and Exclusive Service Suppliers. 161 Aaditya Mattoo, above note 152. 162 The share of private sectors in GDP varied in the transition economy members at the time of their accessions, ranging from a high of 80% in the case of Georgia to a low of 27% in the case of Bulgaria. See WTO, Report of the Working Party on the Accession of Georgia, WT/ACC/GEO/31, 31 August 1999, p. 6; Report of the Working Party on the Accession of Bulgaria, WT/ACC/BGR/5, 20 September 1996, p. 13. Also instructive is the situation of several transition economies at the time they became original WTO members. As of 1995, the private sector accounted for 60% of the GDP in the Czech Republic, 70% in Hungary, 59% in Poland, and 62% in Slovakia. See Michael S. Borish and Michel Noel, ‘Private Sector Expansion in Central Europe’, World Bank, Transition Newsletter, available at www.worldbank.org. 163 See WTO Secretariat, Technical Note on the Accession Process, WT/ACC/10/Rev.1, 28 May 2003, at 49-52.

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It should be noted that, apart from the SOE-based specificity test, the China Protocol appears to be generally ownership-neutral. There is no Protocol provision requiring China to reduce state ownership in its economy. The only substantive obligations regarding SOEs closely follow the tenet of GATT Article XVII, requiring the government to ensure that all SOEs in China act solely in accordance with commercial considerations.164

The SOE-based specificity test, therefore, is a rather curious departure from the principled

position otherwise maintained by the WTO. Further, since the provision singles out China’s state ownership as a special target for trade remedies without the support of an economic rationale or other legitimate policy reason, it appears to be an unjustified departure from the fundamental WTO principle of non-discrimination.165 B. NME Anti-Subsidy Methodologies

As previously discussed, pursuant to Article 14 of the SCM Agreement, the proper benchmarks to be used in calculating the amount of a subsidy are generally market conditions prevailing in the subsidizing country.166 Section 15(b) of the Protocol provides an exception to Article 14 in that it permits the importing WTO member to resort to alternative benchmarks if it finds prevailing conditions in China inappropriate to use. The rationale of Section 15(b) seems easy to understand. Given the level of government influence in the Chinese economy and the less than fully developed market conditions in certain industries and sectors (the financial sector in particular), prevailing terms and conditions in China may not always be appropriate as market benchmarks for purposes of Article 14.

The rationale of Section 15(b) appears to be consistent with the opinion of the Appellate Body

in US – Lumber CVD Final.167 In that case, the Appellate Body reversed the Panel’s finding that the prevailing market conditions in the case of provision of goods or services under Article 14(d) are those that actually exist in the country of provision (in this case, Canada) even if that market has been affected by government intervention. It held instead that an alternative benchmark may be used for purposes of Article 14(d), provided that two conditions are met: (i) the investigating authority has established that ‘private prices of the goods in question in the country of provision are distorted, because of the dominant role of the government in the market as the provider of the same or similar goods,’ and (ii) the alternative benchmark ‘relates or refers to, or in connected with, prevailing market conditions in the country of provision.’168 The Appellate Body, on the grounds of insufficient factual basis, did not make a finding as to whether the alternative benchmark used by the United States in that case – market prices prevailing in the United States – met the two conditions. Its opinion, however, has opened the door for questioning in all future subsidy and countervailing duty cases whether actual

164 See Section III.A.1. above. 165 In theory, all China-specific remedy rules depart from the principle of non-discrimination, since no other member is subject to the same within the WTO. However, ‘[u]nequal treatment is never called discriminatory when the reason for differential treatment is considered legitimate.’ Robert E. Hudec, ‘Tiger Tiger, In the House: A Critical Appraisal of the Case Against Discriminatory Trade Measures’, in Robert E. Hudec, Essays on the Nature of International Trade Law (Cameron May, 1999), 281, at 322. 166 See above text at note 123. 167 Above note 5. 168 Ibid., para. 167.

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market conditions are appropriate benchmarks in any subsidizing member, be it a mature market economy like Canada or a transition economy like China.169

There are, of course, differences between the requirements of Article 14, as interpreted by US – Lumber CVD Final, and that of Section 15(b) of the Protocol – otherwise there would have been no need for the China-specific provision. Presumably, when an importing member invokes Section 15(b), it will claim that there are ‘special difficulties’ in application of Article 14 to a Chinese subsidy.170 Such a claim would effectively render inapplicable in the Chinese case the two conditions imposed by the Appellate Body for using alternative benchmarks under Article 14(d), i.e., that the investigating authority has established that Chinese prices are distorted and that the alternative benchmarks used relate to prevailing market conditions in China. In other words, Section 15(b) enables an importing member to use alternative benchmarks in the case of a Chinese subsidy without having to comply with the requirements of Article 14 as interpreted under existing WTO jurisprudence.

At first glance, Section 15(b) of the Protocol seems to have filled a void in WTO law. For the

first time the world trade system provides a rule to deal with the potential difficulty in identifying and calculating a subsidy in a transition economy.171 Further consideration, however, reveals at least two major problems with the provision. First, its authorization for the use of alternative benchmarks is made on a permanent basis regardless of the status of the Chinese economy. Technically, an importing member may invoke the provision in a countervailing action against a Chinese subsidy, say, fifty years from now, irrespective of whether by then China may have long established a mature market economy. The permanent duration of Section 15(b) stands in contrast to all other China-specific remedy provisions of the Protocol, i.e., the special antidumping provisions under Section 15, the product-specific safeguard under Section 16 and the special textile safeguard provision,172 which are valid for 15, 12 and 7 years, respectively, from the date of China’s accession. The limited duration of these special remedy provisions reflects an understanding that discriminatory treatment of Chinese exports can only be justified on a transitional basis.173 This understanding is made abundantly clear in the special antidumping provisions, which expressly link the use of NME antidumping methodologies to the development of market conditions in China.174 The inconsistent treatment between the subsidy remedy and other special remedies, especially the use of NME methodologies in antidumping cases,

169 Although the Appellate Body’s opinion in this case is limited to the interpretation of Article 14(d), which concerns the government provision of goods or services, the rationale of this opinion may well be extended to the interpretation of other provisions of Article 14 regarding equity infusion, loans and loan guarantees. 170 See Section 15(b) of the Protocol. 171 See Section I.D above. 172 WPR, para. 242, which was incorporated into the Protocol. 173 It is beyond the scope of this study to comment on the merits of these special remedies. For an analysis of the special antidumping provisions, see Lei Yu, ‘Rule of Law or Rule of Protectionism: Anti-Dumping Practices Toward China and WTO Dispute Settlement System’, 15 Colum. J. Asian L. (Spring 2002) 293. For a critique of the product-specific safeguard, see Yong-Shik Lee, ‘The Specific Safeguard Mechanism in the Protocol on China’s Accession to the WTO: A Serious Step Backward from the Achievement of the Uruguay Round’, 5(2) J. World Intellectual Property (March 2002) 219. See also Fabio Spadi, ‘Discriminatory Safeguards in the Light of the Admission of the People’s Republic of China to the World Trade Organization’, 5(2) JIEL (2002) 421. 174 Sections 15(a) permits the importing member to use NME methodologies only when the Chinese producer under investigation ‘cannot clearly show’ that market economy conditions prevail in the relevant industry in China. Further, Section 15(d) requires the importing member to cease to use NME methodologies once China has categorically established that it is a market economy under the national law of the importing member, provided that such national law contains market economy criteria as of the date of China’s accession.

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defies logic. Neither the Protocol nor the Working Party Report offers an explanation for such inconsistency.

Secondly, the brief text of Section 15(b) lacks both substantive and procedural details to guide the members in practice. It does not specify, for example, what factors the importing member should consider in judging the appropriateness of prevailing conditions in China. Nor does it mention whether and how the Chinese producer under investigation may rebut the claim that Chinese benchmarks are inappropriate in the relevant proceedings. Consequently, the implementation of this provision is left entirely to the discretion of the importing member.175 In practice, the importing member could dismiss prevailing conditions in the Chinese marketplace whenever it believes there are ‘special difficulties’ in applying the standard methodologies of Article 14 and make whatever adjustments it deems appropriate to the Chinese prices or simply employ prices in another country, including its own, as the basis for comparison. Judging from the protectionist effect of using NME methodologies in antidumping actions,176 one can expect the application of Section 15(b) to result in no less such effect.

As previously noted, the object and purpose of the SCM Agreement is ‘to strengthen and

improve GATT disciplines relating to the use of both subsidies and countervailing measures, while, at the same time, recognizing the right of Members to use such measures under certain conditions.’177 The Protocol provides members with the right to use alternative methodologies in applying countervailing measures to Chinese subsidies, but fails to place necessary conditions for such use. As a result, it weakens rather than strengthens GATT disciplines on countervailing measures.

It should be noted that the impact of Section 15(b) may not be felt immediately. For domestic

legal reasons, the United States, the most frequent user of countervailing measures, does not apply its countervailing duty law to ‘non-market economy’ countries;178 and it continues to treat China as an NME for purposes of its trade law.179 The US practice seems to have influenced other countries in this regard. As of the end of 2003, no WTO member had reported any countervailing duty investigation

175 Given the little constraint placed by the Protocol on the discretion of the importing member, it would be difficult for WTO panels and the Appellate Body, through their interpretation of the provision, to impose any effective discipline on the countervailing measures taken under Section 15(b). 176 The use of NME antidumping methodologies is intrinsically biased against the targeted country. According to one study, the average dumping margins determined under NME methodologies were 40% in the U.S. and 45.6% in EC, as compared to 3.2% in the U.S. and 22.7% in EC under pure price comparisons and 25.1% in both the U.S. and EC under various constructed value methods during the same period. See Patrick A. Messerlin, ‘China in the WTO: Antidumping and Safeguards’ (14 December 2002), Table 7 (statistics based on examination of 141 U.S. antidumping cases (1995-1998) and 67 EC cases (1995-1997)), available at University of Cambridge – Royal Institute of International Affairs – The China Project, http://www.riia.org. The use of NME methodologies can not only inflate dumping margins, but also increase the chance of finding dumping. For a critique of abuse of NME methodologies in antidumping actions against transition economies, see Polouektov, above note 30. 177 Appellate Body Report, US – Lumber CVD Final, above note 5. 178 See above note 28. 179 China has repeatedly requested that it be given the status of a market economy under US law. Ironically, if China does obtain such status, the US could immediately use countervailing duty actions against Chinese products. It should also be noted that whether China is treated as a market economy for the purposes of national trade law of a particular country is an entirely separate matter from whether China is a transition economy in its true sense.

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involving China.180 Instead, importing members have more readily relied on the use of NME antidumping methodologies and special safeguards against Chinese products. For example, the United States invoked the special textile safeguard against three Chinese textile products in 2003, citing subsidies by state-owned banks to SOEs in the textile industry as ‘moral’ justification for the measure.181 Various WTO members have also resorted or threatened to resort to the special safeguard against China.182 And China has been by far the most frequently targeted country for antidumping measures in the world.183

However, the practice of eschewing countervailing measures against China appears to be

ending. For example, Canada recently imposed a provisional countervailing duty on China-made outdoor barbecues,184 and it has initiated a separate countervailing duty investigation into subsidization of certain steel fasteners from China.185 In the United States, bills have been introduced in the Congress to amend US trade law so as to allow the application of anti-subsidy measures to China.186 After all, there is no legal obstacle under WTO law for the immediate implementation of Section 15(b) of the Protocol. Indeed, in light of the continuing phenomenal growth of Chinese exports, and also in anticipation of the expiration of other special trade remedies in the next few years, it seems safe to predict that WTO members will become increasingly inclined to resort to countervailing measures and

180 For the period from January 1, 1995 to December 31, 2003, a total of 16 WTO Members initiated 168 countervailing duty investigations against products of 39 exporting countries, which include Poland, Hungary and the Czech Republic, but not other transition economy countries. See WTO, Subsidies and Countervailing Measures: Statistics, available at www.wto.org. 181 See BNA, International Trade Reporter, ‘Bush Administration to Restrain Textile and Apparel Imports from China’ (20 November 2003). Although the safeguard is legally based on the concept of import surge and market disruption, U.S. Commerce Undersecretary for International Trade, Grant Aldonas, also cited Chinese textile industry being ‘heavily state-owned’ and receiving ‘subsidies’ from ‘state-owned banks.’ Ibid., available at www.bna.com. 182 For instance, India imposed a special safeguard duty on industrial sewing machine needles from China in April 2003. See WTO, G/SG/Q2/IND/8, 18 November 2003. On 5 December 2003, the US requested consultations with China pursuant to Section 16.1 of the Protocol concerning imports of certain ductile iron waterworks fittings of Chinese origin. WTO, G/SG/69, 20 January 2004. Prior to that, the US had made several investigations under Section 16 but none of the previous investigations led to a consultation request. On January 22, 2004, Poland requested consultation with China under Section 16.1 regarding imports of footwear. WTO, G/SG/70, 26 January 2004. It was reported that EU began a special safeguard investigation on imports of tinned oranges from China in the summer of 2003. China Daily, 31 July 2003, available at www.chinadaily.com.cn. 183 For the period from January 1, 1995 to December 31, 2003, WTO members reported a total of 1511 antidumping measures, of which 254 were taken against Chinese products, followed by a distant second of 107 measures against South Korea. For the same period, a total of 2416 antidumping investigations were initiated, of which 356 involved Chinese products. See WTO, Antidumping – Statistics, available at www.wto.org. 184 Canada Border Services Agency, News Releases, The Canada Border Services Agency imposes provisional duty on outdoor barbecues (27 August 2004), available at www.cbsa-asfc.gc.ca/sima. 185 Canada Border Services Agency, Statement of Reasons Concerning the Initiation of an Investigation into the Dumping and the Subsidization of Certain Carbon Steel and Stainless Steel Fasteners Originating in or Export from the People’s Republic of China and Chinese Taipei, 4243-38 AD/1308, 4218-17 CVD/103 (13 May 2004), available at www.cbsa-asfc.gc.ca/sima. 186 H.R. 3716 and S. 2212 include sections that amend US trade law to allow countervailing duties to be used against subsidies provided by NMEs including China. See Reps. English, Artur Davis & Sens. Collins, Bayh Target China, ‘Stump for Bill to Expand Trade Relief for U.S. Companies’, News Release (31 March 2004), at www.house.gov/apps/list/press/pa03_english/ChinaNME.html. Past attempts by some in the Congress to legislate on the subject failed. Jackson, above note 6, at 336.

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the WTO dispute settlement procedure against Chinese subsidies. The open-ended provision of Section 15(b), coupled with the SOE-based specificity test, will serve to provide domestic producers of WTO members with a much longer period of special protection from Chinese competition. Correspondingly, these special provisions are likely to become a major source of future contention at the WTO. C. Exclusion of China from Invoking the Privatization Exception In accordance with Article 27.13 of the SCM Agreement, when a developing country member grants a domestic subsidy ‘within and directly linked to’ a privatization program, whether in the form of direct forgiveness of debts or in whatever form to cover social costs, the subsidy is not actionable at the WTO multilateral forum, provided that it is notified to the WTO, is granted for a limited period, and the SOE involved is eventually privatized.187 This provision apparently is intended to encourage developing country members, whose economies tend to rely on SOEs more than developed countries, to privatize their state-owned sectors.188

Instead of providing the same encouragement to China, however, the Protocol explicitly

excludes China from the benefit of Article 27.13.189 Manifestly, the exclusion of China from invoking Article 27.13 could have an adverse impact on the SOE reform since China has been increasingly resorting to privatization, partial or full, as a solution to its SOE problem.190 In the context of privatization, the government has typically provided financial assistance through forgiveness of debts, subsidies to cover social costs (such as taking over retirees and laid-off workers of the SOEs), direct transfer of liabilities, and tax benefits, all covered by Article 27.13. The inability of China to invoke Article 27.13 renders these efforts fully exposed to potential WTO actions.

Under WTO law, as previously noted, a privatized firm may be found to continue to benefit from a pre-privatization subsidy.191 Though the SCM Agreement does not explicitly address the issue of a change in ownership, the effect of pre-privatization subsidies has been dealt with in US – Lead Bars and US – CVD on EC Products,192 both involving EC challenges to U.S. countervailing duties imposed to offset subsidies provided to former SOEs. According to the Appellate Body, where privatization is at arm’s length and for fair market value, there is ‘a rebuttable presumption’ that a benefit conferred by a pre-privatization subsidy ceases to exist after the privatization, but it does not necessarily do so.193 The Appellate Body indicated several situations in which a benefit conferred to an SOE might not extinguish after privatization, such as where the benefit is conferred through ‘recurring financial contributions’ or where the government ‘retains a controlling interest’ in the firm following

187 See Section I.B.1. above. 188 See above note 150 and text at note 159. 189 Above note 102. 190 See Section II.B.1(b) above. 191 See above text at notes 11 and 12. 192 Above note 11. 193 Appellate Body Report, US-CVD on EC Products, above note 12. The Appellate Body reversed the Panel’s finding that privatization at arm’s length and for fair market value necessarily extinguishes the benefit bestowed upon the state-owned producer by a prior financial contribution. ‘The effect of such privatization is to shift to the investigating authority the burden of identifying evidence which establishes that the benefit from the previous financial contribution does indeed continue beyond privatization.’ Ibid., para.126.

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privatization,194 and where the market valuation of the SOE property is ‘severely affected’ by government policies or ‘by the conditions in which buyers will subsequently be allowed to enjoy property’.195

All of these situations identified by the Appellate Body exist in China. As discussed in Section

II above, partial privatization of SOEs, in which the government retains a controlling interest in the enterprises sold, is a major form of China’s SOE reform strategy. Historically, the government’s financial contribution to subsequently privatized SOEs, either through equity infusion or discounted loans or tax benefits, tends to be recurring. Many sales of SOEs have been arranged by the government and therefore are not necessarily at arms’ length and for fair market value. Even for sales through listing on stock exchanges or private placement to strategic investors, it can be difficult to establish a ‘fair market valuation’ of the SOE property involved. Given the transitional nature of the Chinese economy, the relevant market conditions in China might be considered so heavily influenced by government economic and other policies that they could not be deemed as capable of producing a fair market value for the SOE privatized in the sense described by the Appellate Body. Though the Appellate Body discussed these situations in the context of countervailing duty investigations under Part V of the SCM Agreement, its analyses interpret the existence of a ‘benefit’ within the meaning of Article 1 of the SCM Agreement, and therefore should also be applicable to actions brought to the WTO forum under Part III of the SCM Agreement. Thus, the exclusion of China from the benefit of Article 27.13 should cause additional concern for private firms, domestic or foreign, that have invested or will be investing in Chinese SOEs.196

The reason for excluding China from the benefit of Article 27.13 is puzzling. According to the

Working Party Report, some WTO members felt that it would be inappropriate for China to benefit from the special treatment granted to developing countries under Article 27 because ‘the special features of China’s economy, in its present state of reform, still created the potential for a certain level of trade-distorting subsidization’ that ‘should be subject to effective SCM Agreement disciplines.’197 It is difficult, however, to follow the logic of this concern with respect to Article 27.13. In order to move beyond ‘its present state of reform’, China needs to pursue more privatization, whereas the very purpose of Article 27.13 is to encourage privatization in developing economies. Since extensive state ownership in developing countries is thought to create market distortion, any trade-distorting effect of subsidies granted in the context of privatization is to be balanced against the effect of such subsidies to correct market distortion. It is unclear why the economic logic of Article 27.13 should not be applied to China.

The exclusion of China from invoking Article 27.13 may also have negative implications for

the WTO dispute settlement system. Due to the transitional nature of the Chinese economy, situations

194 Ibid., para. 117. 195 Ibid., para. 123. The Appellate Body elaborated that, in privatization of an SOE, the government is ‘not necessarily always a passive price taker’ and that it has ‘the ability, by designing economic and other policies, to influence the circumstances and the conditions of the sale so as to obtain a certain market valuation of the enterprise.’ Ibid., para. 124. In addition, the Appellate Body suggested the possibility that ‘some of the financial contribution provided to owners may not flow into the firm’, hence the shareholders and the privatized firm may not always be considered as one recipient for the purpose of calculating the benefit under the SCM Agreement. Ibid., para. 118. 196 Since Article 27.13 does not apply to Part V of the SCM Agreement, private investors in Chinese SOEs are fully exposed to countervailing action against pre-privatization subsidies. See Section I.B.1. 197 WPR, para. 171.

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involved in a pre-privatization subsidy in China can be far more complex and of a much larger scale than those identified by the Appellate Body in the above-noted cases. From an institutional perspective, how to treat subsidy issues arising in connection with privatization in transition economies should be a matter of WTO policy. Such policy issues are better dealt with by the ‘legislative’ process than left to the adjudicatory procedure for resolution on a case-by-case basis.198 Unfortunately, the SCM Agreement sets out no general rules dealing with the special issues of subsidies in transition economies (other than the transitional arrangement in Article 29). Yet, at the same time, thanks to Article 27.13 these issues are unlikely to arise in the proceedings brought under Part III of the SCM Agreement199 since virtually all of the transition economy members are also developing countries entitled to invoke the privatization exception. In the case of China, however, without the benefit of Article 27.13 the WTO dispute settlement forum may soon confront such issues, whose magnitude and policy implications might prove to be beyond its authority and capability to resolve properly. D. Lack of a Transitional Period for China to Phase Out SOE Subsidies As previously discussed, subsidization of SOEs is a historical issue for nations in the process of transformation from a centrally-planned to a market-based economy.200 Though the special circumstances of the transition economy are not contemplated by the basic WTO subsidy disciplines, the SCM Agreement does provide an exception for subsidies used by transition economy members so as to accommodate the emergence of a large number of transition economies in the post-Cold War era. Specifically, Article 29 of the SCM Agreement permits such members to use subsidies ‘necessary’ for the transformation of their economic systems,201 and grants them a seven-year transitional period to fully comply with the SCM disciplines.202

198 For a discussion of the asymmetry in architectural design of the WTO between weak legislative and executive functions on the one hand and strong judiciary procedures on the other, see Sylvia Ostry,‘The World Trading System: In Dire Need of Reform’, 17 Temp. Int’l & Comp. L. J. (Spring 2003) 109. 199 These situations, however, may still arise in WTO proceedings brought under Part V of the SCM Agreement since Article 27.13 only exempts privatization subsidies of developing country members from Part III proceedings. 200 See Section I.B.2. 201 Article 29 Transformation into a Market Economy reads:

29.1 Members in the process of transformation from a centrally-planned into a market, free-enterprise economy may apply programmes and measures necessary for such a transformation. 29.2 For such Members, subsidy programmes falling within the scope of Article 3, and notified according to paragraph 3, shall be phased out or brought into conformity with Article 3 within a period of seven years from the date of entry into force of the WTO Agreement. In such a case, Article 4 shall not apply. In addition during the same period:

(a) Subsidy programmes falling within the scope of paragraph 1(d) of Article 6 shall not be actionable under Article 7;

(b) With respect to other actionable subsidies, the provisions of paragraph 9 of Article 27 shall apply. 29.3 Subsidy programmes falling within the scope of Article 3 shall be notified to the Committee by the earliest practicable date after the date of entry into force of the WTO Agreement. Further notifications of such subsidies may be made up to two years after the date of entry into force of the WTO Agreement. 29.4 In exceptional circumstances Members referred to in paragraph 1 may be given departures from their notified programmes and measures and their time-frame by the Committee if such departures are deemed necessary for the process of transformation.

202 It should be noted that transition economy members that are also developing countries can take advantage of both Article 29 and the privatization exception under Article 27.13. Compared with Article 27.13, the Article 29 exception has a broader scope since it applies to all government measures ‘necessary’ for economic

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This transitional period, however, runs from the date of the entry into force of the WTO

Agreement on January 1, 1995, to December 31, 2001. Consequently, only those transition economies that are original members of the WTO can fully benefit from the transition period.203 Transition economies acceding to the WTO during or after this period receive only partial or no benefit from Article 29.204 Presumably, an acceding transition economy has been on notice of the requirements of the SCM Agreement since January 1, 1995, and therefore has had the same period available to it for adjustment (albeit outside the WTO prior to its accession) as the original members. Further, if desirable, the acceding country could in theory negotiate an additional transition period as part of the terms for its accession, although no acceding member has done so in practice.

The seven-year transition period under Article 29 expired twenty days after China’s accession;

no additional transition period is provided by the Protocol.205 The failure of the Protocol to do so, however, ignores the reality that SOE reforms remain an on-going process in China. Compared with other transition economies, China has a much larger state sector to reform, and its gradual approach toward the reforms also necessitates a longer period of transition.

The lack of a separate transition period for China to sort out its historical SOE problems

exposes many of its reform measures, including some strategic moves, to WTO subsidy disciplines. For example, the government bailout of major state-owned banks is imperative for maintaining the political and economic stability in the country, but may give rise to issues of direct or indirect subsidies under the SCM Agreement.206 Similarly, the new initiative to revitalize the Northeast Region, the traditional industrial base of China that sustains 9% of the Chinese population, could also become subject to the SCM disciplines, as it will involve huge amounts of government funding to revive, restructure or privatize the massive number of ailing SOEs in the region.207

It was readily apparent prior to China’s WTO accession that it would still take years for China

to sort out its SOE problems. In fact, at least one commentator had suggested that China be given a

transformation, whether connected with a privatization program. On the other hand, the Article 29 exception is limited to a seven-year period, whereas Article 27.13 is a permanent provision. 203 These members include the Czech Republic, Slovakia, Poland, Romania, and Hungary. 204 Transition economies that acceded to the WTO before December 31, 2001 include: Mongolia, Bulgaria, Kyrgyz Republic, Latvia, Estonia, Georgia, Croatia, Albania, Lithuania, Moldova, and China. Information on all WTO accessions since 1995 is available at www.wto.org. 205 Annex 5B of the Protocol contains a list of subsidies to be phased out by China by year 2000, prior to China’s entry into the WTO. Such subsidies include subsidies to certain loss-making SOEs, the priority in obtaining loans and foreign currencies based on export performance, and preferential tariff rates based on localization rate of automotive production. 206 See Section II.B.2. 207 Under the revitalization initiative, the first batch of 100 projects approved by the central government would involve investment of RMB61 billion (US$7.3 billion), and the second batch was expected to outnumber the first. ‘NE rejuvenation in operation, NE office to be established’, People’s Daily, 28 November 2003, available at http://english.peopledaily.com.cn. It was reported that the governors of the three provinces of the Northeast Region pledged to employ a range of new financial measures to strive for the region’s revitalization, including forgiveness of corporate debts, government-backed bounds, and a new bank specializing in regional development. The problem of bad assets of SOEs and the welfare of retirees, laid-off and unemployed workers were cited as the two greatest obstacles in the revitalization process. See ‘China’s “Iron belt” readies financial revival’, People’s Daily, 9 January 2004, available at http://english.peopledaily.com.cn.

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longer transitional period to phase out SOE subsidies and preferences in return for broad market access commitments under the WTO.208 Such suggestions, however, were ignored.209 Instead, the Protocol makes all SOE subsidies in China a special target for countervailing action and excludes China from the privatization exception otherwise available to it under the SCM Agreement. The Protocol’s approach contrasts sharply with the spirit of Article 29.

E. The ‘Rationale’ of the Protocol Approach The SOE-based specificity test, the NME methodologies for calculating Chinese subsidies, the exclusion of China from the privatization exception of Article 27.13, and the absence of any transitional period for China to phase out its SOE subsidies, together demonstrate an approach taken by the Protocol that is based predominantly upon the interests of WTO members to protect their domestic producers. As noted before, assuming that the WTO as an institution desires to encourage China to continue its transition to a market economy, a special challenge presented by Chinese SOEs to the WTO is how to balance the need of China to use subsidies in furthering its economic reform against the need to protect other members from adverse trade effects of such subsidies. The Protocol, however, has completely neglected to strike such a balance.210 This one-sidedness of the Protocol approach has also resulted in country-specific rules that are inconsistent with WTO norms and disciplines.

In theory, there seems no reason why the Protocol could not have adopted a more balanced

and principled approach towards the issue of SOE subsidies in China. For example, it should be possible to distinguish different types of SOE subsidies based on their purposes and functions, similar to the approach taken in Articles 27.13 and 29. Accordingly, subsidies necessary for correcting historical market distortions and for furthering market-oriented reforms could be treated differently from those that are used to create strategic SOEs or consolidate SOEs’ dominant position in the industry. In addition or as an alternative, it would have been desirable for the Protocol to provide a cut-off date (e.g., the date of the accession) for recourse against Chinese subsidies. Such an historical approach would eliminate the need for the system ever to deal with the many complex issues involved in subsidies granted under non-market economy conditions, potentially avoiding much friction likely to arise in future WTO disputes.

Why, then, did not a more sensible approach emerge, and instead the one-sided approach prevail? A chief reason appears to lie in the WTO accession system. Pursuant to Article XII of the WTO Agreement, a country may accede to the WTO ‘on terms to be agreed between it and the WTO.’211 The WTO Agreement, however, places no limit on the terms to be so agreed. This opens the possibility of creating applicant-specific rules that cater to the special interests of major trading powers dominating the negotiation process. For all practical purposes, the applicant does not stand on an equal

208 David M. Blumental, ‘Applying GATT to Marketizing Economies: Dilemma of WTO Accession and Reform of China’s State-owned Enterprises (SOEs)’, 2(1) JIEL (1999) 113, at 147. 209 It is unclear whether similar suggestions were ever tabled during the negotiation of China’s accession. Little negotiation history is publicly available. 210 The one-sidedness of the Protocol approach appears even more pronounced when viewed against the level of market access commitments and the general commitments on subsidies made by China. 211 ‘Any State or separate customs territory possessing full autonomy in the conduct of its external commercial relations and of the other matters provided for in this Agreement and the Multilateral Trade Agreements may accede to this Agreement, on terms to be agreed between it and the WTO. Such accession shall apply to this Agreement and the Multilateral Trade Agreements annexed thereto.’ WTO Agreement, Art. XII:1.

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footing with the existing members who are ‘judges’ of its qualifications. In the case of China, it was the bilateral negotiation between the United States and China that finalized the special remedy terms of the Protocol. Typically, accession proceeds on both multilateral and bilateral fronts, with the multilateral negotiation at the accession working party drafting the protocol of accession and bilateral negotiations between the applicant and individual members focusing on market access commitments.212 The bilateral negotiation between China and the United States led to the conclusion of the US-China Agreement of November 15, 1999.213 This agreement, however, contained not only market access commitments of China, but also the ‘Protocol Language’ setting forth the special antidumping, subsidy, and safeguard provisions. These provisions were subsequently adopted, almost verbatim, by the final text of the Protocol. Whereas various ideas of special trade remedies had been introduced in the previous draft of the Protocol for discussion, the SOE-based specificity test appeared for the first time in the US-China Agreement.214 Though China had previously resisted any discriminatory terms at the multilateral meetings of the WTO Accession Working Party,215 it eventually yielded to the US demands during the bilateral negotiation.216

Unfortunately, the one-sided approach adopted by the Protocol has turned out to reflect a

growing sentiment in the world fearing the impact of China’s rise as a new economic power. In the past ten years, China’s GDP more than doubled and its exports in merchandise more than tripled.217 In the meantime, it has become a top destination for foreign direct investment, an engine for exports and economic growth.218 Inevitably, the fast-growing Chinese competition threatens the economic status quo in many parts of the world, developed and developing countries alike. What seems to be forgotten in recent times, however, is the fact that China has responsibility for the welfare of 20% of the world population and is still struggling with severe structural problems in its transitional economy. As one commentator well observed:219

In the rush to embrace [China’s] miracle growth, there is little appreciation of what is most important to China: the overarching imperative to stay the course of reforms without disturbing social stability. Critical to this process is the unrelenting restructuring of the SOE network, resulting in the annual elimination of some 7.29m state-funded jobs. China’s reforms

212 See WTO Secretariat, Technical Note on the Accession Process, above note 163. 213 The Agreement on Market Access Between the People’s Republic of China and the United States of America, 15 November 1999. Source: Office of U.S. Trade Representative (on file with the author). 214 For the previous draft of the Protocol in 1997, see Sean Leonard, The Dragon Awakens: China’s Long March to Geneva (Cameron May, 1999), Appendix 2. 215 See Jeffrey Gertler, ‘The Process of China’ Accession to the World Trade Organization’, in Abbott (ed.), above note 1, p. 65, at 71. 216 The high-handed negotiating tactics deployed by the U.S. Trade Representative in that negotiation were widely reported. See e.g., ‘To Brink and Back: In Historic Pact, U.S. Opens Way for China to Finally Join WTO’, Wall Street Journal, 16 November 1999, p. A1; ‘“Roller-Coaster Ride” to an Off-Again, On-Again Trade Pact’, The Washington Post, 16 November 1999, p. A26; ‘The Fist Lady of Trade: Woman in the News Charlene Barshefsky: The US trade representative was praised after China’s accession to the WTO...’ Financial Times (London) 27 November 1999, p. 11. On the part of China, the lack of sufficient experience and expertise in WTO matters may have constrained its ability to better assert its interests in the negotiation of the special rules. 217 China’s nominal GDP was RMB4.6 trillion in 1994 and RMB11.67 trillion in 2003. The value of its exports in goods was US$121 billion in 1994 and $438 billion in 2003. Source: US-China Business Council, China Statistics and Analysis, available at www.uschina.org.; Lardy, above note 34, Table 1-1. 218 Foreign-invested enterprises accounted for more than half of China’s exports in 2002. See above note 45. 219 Stephen Roach, ‘The hard argument for China’s soft landing’, The Financial Times, 15 January 2004, p. 13.

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are all about creating a market-based alternative to its antiquated SOE sector and sustaining a vigorous growth climate capable of re-employing most of the displaced workers.

It is regrettable that the Protocol has not provided a more supportive legal framework to help China meet such an extraordinary macro-economic challenge. V. Conclusions and Recommendations

Chinese subsidies in general, and SOE subsidies in particular, present special challenges to the world trading system because they occur in a giant transition economy. The existing WTO subsidy disciplines assume conditions of a typical market economy, and do not contemplate the special circumstances of a transition economy – that is, an economy in the process of transformation from a centrally-planned into a market-based system.

There are at least two special circumstances of a transition economy that merit special

consideration. First, because market conditions may not have been fully developed, it might be difficult to identify the existence and size of subsidies in the transition economy due to a lack of proper market benchmarks. As a result, the WTO subsidy disciplines may not function effectively. Second, government subsidies may play a special role in the transition economy. In order to correct past distortions created by the central planning system, to privatize the state sector, and to ease the political and social repercussions caused by structural changes in the economy, the government may need to provide financial assistance to specific enterprises, industries and regions. Such assistance, however, may run afoul of the WTO subsidy disciplines. Both of these special circumstances exist in China. In fact, due to the sheer size of its economy and the gradual approach it has taken to reform its system, the special features of the transition economy manifest themselves in China in a more pronounced manner.

When a large number of transition economies emerged in the early 1990’s, the world trading system faced the question of how to address their special circumstances. In the end, the solution offered by the Uruguay Round was Article 29 of the SCM Agreement. Rather than imposing a special discipline on subsidies used by transition economy members, Article 29 exempts such subsidies from WTO challenges for a seven-year period provided certain conditions are met. Article 29 therefore reflects the recognition by WTO members of the special role subsidies may play in the transition economy.

In contrast with the arrangement of Article 29, the Protocol has adopted a completely different approach towards subsidy issues arising from the transitional nature of the Chinese economy. Instead of granting any exception to subsidies used for purposes of economic reforms, the Protocol establishes two special remedy rules to protect producers of other members from potential adverse effects of Chinese subsidies. First, the SOE-based specificity test of the Protocol makes subsidies to SOEs in China automatically specific under the SCM Agreement, regardless whether they may be necessary or even beneficial for furthering economic reforms. Second, the Protocol authorizes the importing member to use the so-called NME methodologies to identify Chinese subsidies, but imposes few conditions on such use. As a result, such methodologies are permanently available to an importing member in countervailing actions against Chinese subsidies, regardless of the nature of China’s economy. In addition, the Protocol excludes China from invoking most of the special treatment granted to developing country members under the SCM Agreement, including the exception for subsidies used in the context of privatization.

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What are the differences between China and the other transition economies that would warrant such a different approach to subsidization in China? At least two factors can be identified: a distrust of state ownership among major WTO members (the United States in particular) and the fear of the ‘China threat’. Although the WTO system is legally ownership-neutral, its norms and rules assume the conditions of a market economy that is typically dominated by private ownership. Unlike many transition economies that carried out large-scale privatization in the early stage of their reforms, China has never embraced mass privatization. While in reality the state share in the Chinese economy has decreased to about 30% of the GDP, this reduction was achieved through a rapid growth of the non-state sector as well as restructuring of SOEs. Officially, the government remains committed to the idea of ‘a socialist market economy’, which is characterized by a market-based pricing system and a mixed ownership structure with the state sector maintaining a dominant position. Regardless of the label, scholars debate as to whether the Chinese-style reform is merely a gradual ‘institutional convergence to a prototype WTO market economy’ or a grand social experiment with a very different economic institution.220 Meanwhile, it seems certain that the state-owned sector will remain a major component of the Chinese economy at least for the foreseeable future.

Furthermore, compared with other transition economies, China has a much greater trading

capacity. The early success of its economic reforms has enabled China to become a major exporting power in the world in a relative short period. The phenomenal growth of the Chinese economy has caused much concern to other WTO members that are losing market share to Chinese competition. This fear for the ‘China threat’, combined with the distrust of state ownership, appears to be the main motivation behind the Protocol approach.

This Protocol approach, however, is seriously flawed. As demonstrated above, there is no

economic logic or empirical evidence showing that subsidies to SOEs in China are inherently more trade-distorting. Since the SOE-based specificity test targets all SOE subsidies in China without distinguishing their purposes and functions, its use can be counterproductive for the SOE reform, which is at the core of economic reforms in China. Absent the support of an economic rationale or other legitimate policy reasons, the provision of the special test appears to be an unjustified departure from the ownership neutrality of the WTO legal system and the fundamental WTO principle of non-discrimination. Meanwhile, the lack of information and disclosure on SOE subsidies in China, a real problem with SOEs that can render WTO subsidy disciplines ineffective, remains insufficiently addressed by the Protocol.

If one believes that the SOE-based specificity test reflects a policy preference of WTO

members for private ownership, then the exclusion of China from invoking the privatization exception appears to be in direct contradiction to such policy. In light of WTO case law regarding the effect of pre-privatization subsidies, private investors in Chinese SOEs are now directly exposed to future litigation at the WTO. Without the right to invoke the privatization exception, China’s efforts to encourage foreign and domestic private investors to purchase its SOEs may be hindered.

The provision authorizing the use of NME methodologies in identifying Chinese subsidies is

also problematic. While it seems sound to provide such alternative methodologies because proper benchmarks may not exist in the Chinese marketplace, there is no reason why such use should be made permanently available to the importing member and unlinked to the status of market conditions

220 Woo, above note 94, at 109. For a debate between the convergence school and the experimentalist school of thoughts, see Jeffrey D. Sachs and Wing Thye Woo, ‘Understanding China’s Economic Performance’, 4(1) J. Economic Reform (2000) 1-50.

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in China. In this regard, this provision is inconsistent with other special remedy provisions of the Protocol (i.e., special antidumping and safeguard measures), each of which is designed as a transitional device with a built-in expiration date. Moreover, there is little multilateral discipline imposed on the use of such methodologies. As a result, this provision can be easily abused in unilateral countervailing actions.

What, then, are the implications of the Protocol approach for the WTO legal system? At the

rule level, the flaws and defects in the special provisions cannot help but compromise the integrity of the WTO Agreement. At the institutional level, the Protocol approach may cause undesirable constraints on the WTO dispute settlement system in the future. Although to date there have been very few countervailing investigations initiated, and no WTO case brought, against Chinese subsidies, the situation may soon change. With trade friction on the rise between China and other WTO members, and as the dates of expiration for the special safeguards and antidumping provisions of the Protocol draw nearer, resort to the special remedies against Chinese subsidies is bound to increase. The permanence of the special subsidy rules and the lack of any exception for Chinese subsidies granted during its economic transition may in the future result in an overload of Chinese subsidy cases at the WTO. As existing WTO case law shows, subsidy issues involving privatization, the specificity test and the choice of marketplace benchmarks can be exceptionally complex and difficult to address. In the case of China, the transitional nature of its economy and defects and deficiency in the relevant Protocol provisions can only further compound the difficulties in the interpretation of applicable WTO rules. In the event, it may prove extremely difficult, if not impossible, for WTO panels and the Appellate Body to render decisions within their authority that are based on a coherent rationale and clear reasoning. The problems of the Protocol approach have also exposed a serious flaw in the WTO rulemaking system – the possibility of creating member-specific rules in the accession process without proper guiding principles.221 Unlike the general ‘legislative’ process at the WTO, where trade rules are enacted based on compromises among different interests and subject to the scrutiny of multilateral negotiations, in the accession process an applicant does not, for all practical purposes, stand on an equal footing with the existing members. When rules (as opposed to market access concessions) can be made ad hoc to bind a particular applicant, the process is inevitably susceptible to the influence of special interests of the existing members. Furthermore, when the applicant-specific rules can be made in bilateral negotiations in the same way tariff concessions are bargained for, there is no effective check at the multilateral level on the integrity of such rules. It has been more than two years since China acceded to the WTO. Fortunately, there has been little sign that China’s giant state-owned sector is ‘ripping the fabric of the WTO’ as warned by Hufbauer. Perhaps that is because China has substantially liberalized its SOEs in the last few years – its WTO commitments certainly have reduced the barriers and privileges protecting its SOEs in the past. Or perhaps it is still too soon for WTO members to assess the adverse effects of SOE subsidies. Alternatively, it is also possible that the potential trade effects of SOE subsidies were overestimated. Nonetheless, one would be well advised to continue to heed Hufbauer’s warning for another reason. The failure of the Protocol to adopt a historical solution to the issue of Chinese SOE subsidies may well open the floodgate for future disputes involving such subsidies, and the Protocol provisions have created a considerable level of uncertainty over the resolution of such disputes.

221 See Qin, above note 77, for a general critique.

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Accordingly, it would be wise to contemplate an amendment to the Protocol sooner rather than later, even though the current system makes it very difficult to do so.222 The amendment should be made consistent with WTO norms and principles and should aim at strengthening multilateral disciplines over subsidies and countervailing measures. Specific revision could be made along the following guidelines:

(1) Delete the SOE-based specificity test from Section 10.2 of the Protocol and leave the issue of whether a particular SOE subsidy is specific to be determined by the standard provisions of Article 2 of the SCM Agreement. If for whatever legitimate reason the special test is to be retained, such reason should be stated explicitly. (2) Allow China to invoke the privatization exception under Article 27.13 of the SCM Agreement. (3) Amend Section 15(b) of the Protocol. First, impose a time limit on the duration for the use of NME anti-subsidy methodologies. Such duration should be no longer than that available for the use of NME methodologies in antidumping actions under Section 15(a). If a longer period is deemed necessary, the reason for it should be explained. Second, provide concrete substantive conditions and procedural safeguards for the use of such NME methodologies.

(4) Add a special obligation for China to disclose separately its SOE subsidies, including in particular subsidies granted through state-owned banks. Unlike the SOE-based specificity test, a special obligation to disclose SOE subsidies can be fully justified by the WTO principle of transparency since government dealings with SOEs are related-party transactions in nature that are inherently non-transparent. To the extent that it might be difficult to collect data concerning certain past subsidies, the obligation may be provided on a forward-going basis from a specific date. Failure to comply with the disclosure obligation may be considered a factor by the importing member in deciding whether to use NME methodologies under Section 15(b) as amended.

The above recommendations barely go beyond the steps necessary to rectify or improve some of the most problematic provisions of the Protocol. However, it is the hope of this author that this preliminary study on Chinese SOEs has helped to demonstrate the necessity for rethinking the role of subsidies and WTO subsidy rules in general, as suggested by Jackson. For example, should WTO subsidy disciplines regulate different types of subsidies according to their purposes as well as their trade effects? How should the WTO deal with subsidy issues arising from economies that do not fully conform to the prototype market economy? Is there any legitimate reason for imposing a special discipline on SOE subsidies other than requiring better disclosure? How can the WTO enforce its disciplines on notification of subsidies in general and SOE subsidies in particular? These and other related questions deserve further thought and study.

[End]

222 Since the Protocol is made an integral part of the WTO Agreement, its revision is subject to the procedure for amendment under Article X of the WTO Agreement.