China's Virus May Break Phase One Deal
An analysis by Michael Lelyveld 2020-02-07 -- Just two weeks after the United States and China called a truce in their two-year trade war, the outbreak of the coronavirus has threatened to put the agreement on hold.
On Jan. 30, a Chinese trade agency said it would offer "force majeure certificates" to companies facing problems meeting their international contractual commitments due to the epidemic, Reuters reported.
The statement by the China Council for The Promotion of International Trade (CCPIT) may be the first sign that Beijing will invoke force majeure, a legal principle that can exempt parties from contractual obligations in case of circumstances beyond their control.
The CCPIT declaration at the end of January came as Chinese health authorities reported 7,711 confirmed cases of the infection and 170 deaths. Confirmed cases and deaths have more than tripled since then.
"Some Chinese companies have suffered severe impacts on goods and logistics and may not be able to fulfil their contracts amid the coronavirus," the trade agency said.
By opening the door to force majeure claims, China may be calling into question its ability to raise imports from the United States by U.S. $200 billion (1.4 trillion yuan) over the next two years under the Phase One deal.
Even before the dimensions of the coronavirus crisis became known in mid-January, economists and trade experts had voiced doubts that China would fulfill the commitment for such a large increase in imports compared with the base year of 2017.
Economic damage, decreased demand and logistics problems due to the epidemic may have put the goal far out of reach.
"My guess is that there will be substantial shortfalls in the Phase One targets, at least through the first half of 2020, both because the targets are extremely ambitions and because of the coronavirus," said Gary Hufbauer, senior fellow at the Peterson Institute for International Economics in Washington.
Although the text of the Phase One agreement makes no specific reference to force majeure exemptions, it includes a clause calling for consultations "in the event that a natural disaster or other unforeseeable event" delays compliance with the agreement, Bloomberg News noted.
"Even though force majeure is not mentioned in the Phase One text, it's an established legal principle, and I'm sure it will be invoked by China," Hufbauer said.
Bloomberg said it was unclear whether China had formally asked for consultations, but it cited "people familiar with the matter" as saying that plans called for such a request.
In a phone call with U.S. President Donald Trump on Friday, President Xi Jinping raised the issue of the Phase One agreement, saying that "the two countries can always find solutions acceptable to both through dialogue and consultation," according to the official Xinhua news agency.
President Trump responded in Twitter postings with praise for Xi and China's efforts.
"We are working closely with China to help!" he said.
Whether consultations take place or not, force majeure already poses a major risk for the "trade opportunities" that were promised to the United States in the Phase One deal.
The breakdown of increased U.S. exports that China agreed to buy over a two-year period includes U.S. $77.7 billion of manufactured items, $32 billion of agricultural goods, $52.4 billion of energy products and $37.9 billion worth of services.
A postponement or cutback in the targets could spell trouble for the agreement and sectors such as agriculture that have depended on the promised increases after suffering with the effects of tariffs since 2018.
On Tuesday, White House economic adviser Larry Kudlow indicated that the increases in U.S. exports to China are expected to be delayed, Reuters said.
Maritime reports suggest that the virus has been playing havoc with Chinese port operations.
Shortages of cargo handling personnel and truck drivers have been slowing vessel turnaround times and clogging up storage yards, the website splash247.com reported.
"Many shipyards" have already applied for the CCPIT force majeure certificates, the report said.
An automotive parts supplier in coastal Zhejiang province received the first CCPIT certificate on Feb. 2 after failing to meet a scheduled delivery to France's Peugeot SA due to the virus, the official English-language China Daily reported.
"Such (a) certificate will help reduce our economic losses by at least 30 million yuan (U.S. $4.2 million)," said a manager at Huzhou Huida Machinery Manufacturing Co. Ltd.
As of Thursday, more than 1,000 Chinese enterprises had consulted CCPIT and its branches about certification applications, China Daily said.
It is unclear how quickly the use of the certificates will spread as Chinese companies seek to put off obligations under existing contracts. A larger economic impact of the epidemic may result if it prevents new contracts from being signed.
The effects from the CCPIT offer of certificates were felt almost immediately in the markets for liquefied natural gas (LNG), which were already suffering from a drop in Chinese demand after boom years for imports in 2017 and 2018.
LNG prices have fallen to the lowest point in over 10 years, S&P Global Platts news service reported, noting a controversy that has already surfaced over the force majeure declarations.
"China's move is aimed at protecting the interests of domestic companies and helping mitigate their losses," Platts said.
Force majeure card
But it might be too soon to play the force majeure card, since most of China's LNG imports take place under long-term contracts with annual volumes that allow for postponements of deliveries to later in the year.
"It might take some time for China to be able to justify this virus outbreak as force majeure," Platts said. "The key still lies in to what extent China can demonstrate that the contractual requirement cannot be fulfilled."
China has invested heavily in nearly two dozen LNG port terminals following forecasts of continuing demand growth, only to be hit first by an economic slowdown, and then the coronavirus. In January, state-owned China National Petroleum Corp. (CNPC) predicted gas demand would grow at the slowest pace in four years.
International reactions to the epidemic have also chilled the oil market with expectations that demand from the world's leading importer will drop sharply this year. Officials of the Organization of the Petroleum Exporting Countries (OPEC) are considering the need for an emergency meeting to call for further output cuts, The New York Times said.
Signals in China have been mixed, however.
This week, officials in the viral center of Hubei province ordered an increase in discharge volumes from the Three Gorges reservoir to generate more electricity, offsetting lower coal reserves and output from coal-fired power plants, Xinhua said.
The National Energy Administration also directed coal companies to coordinate supplies to regions that are threatened with shortages and "ensure that there are no coronavirus outbreaks at mines under their jurisdiction."
China's energy demand during the epidemic appears unpredictable and may depend on its economic response to the crisis.
This week, the People's Bank of China (PBOC) injected at least 1.6 trillion yuan (U.S. $228.6 billion) into the financial system, signaling that the government means to fight the slowdown with more liquidity.
Force majeure declarations and certificates for existing contracts may generate headlines but they are likely to capture only a small fraction of the economic disruptions from the coronavirus.
Far larger damage may result from travel restrictions, border closings, factory shutdowns and withdrawal of foreign personnel.
If force majeure is declared with respect to the trade opportunities promised in the Phase One agreement, the question of China's foreknowledge is likely to arise.
On Feb. 1, The New York Times reported that Chinese officials at several levels delayed a response to the first signs of the virus in early December for seven weeks by downplaying the dangers in the central city of Wuhan and accusing doctors of spreading rumors.
"The government's initial handling of the epidemic allowed the virus to gain a tenacious hold," the paper said.
The force majeure claim raises the question of what senior Chinese officials knew about the virus on Jan. 15 when the Phase One agreement was signed, and when did they know it.
If force majeure is invoked, U.S. exporters may be entitled to ask whether the epidemic was an "unforeseeable event," or one to which the government turned a blind eye.
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