China Faces Tough Choices
 
Since it entered the WTO in 2001, China has successfully exploited the opportunities provided by that system without adhering to its rules. This has led to explosive growth in Chinese exports, while U.S. manufacturing employment fell precipitously.

What the U.S. needs is the ability to sell what the U.S. specializes in, which are high-end goods and services, in China’s rapidly growing markets without facing informal barriers or fearing loss of sensitive intellectual property to emerging Chinese competitors that have unlimited access to state lending.  That means making China play by the common set of rules it agreed to when it joined the World Trade Organization, and abide by WTO rulings to resolve complaints, just as the U.S. and its other trading partners do when disputes inevitably arise.

Actions in the short-term appear primarity aimed at addressing the superficial concerns of both sides and winning domestic political points.  For instance, “China will buy a “very substantial” amount of U.S. agricultural, energy and industrial goods, with purchases of farm products beginning immediately.”   Ad hoc, state-directed purchases of U.S. goods by China might dent the bi-lateral deficit, but they won’t address the underlying structural issues.
 
A larger impact will come from cuts in formal tariffs.  For instance, China, home to the world’s largest auto market, will remove existing 40 percent tariffs on U.S. auto imports.

Going forward, the argument will focus on Beijing’s promise to “curb” practices such as forced technology transfers, non-enforcement of intellectual property protections, and cyber theft.
In exchange, the U. S. will reduce today’s 10 percent tariffs targeting $200 billion in Chinese imports, rather than raising them to 25%.  Unfortunately, there appears to be little evidence that China actually intends to abandon the mercantilist strategy that it has had in place since at least 2006.

As Phillip Orchard explained recently in Geopolitical Futures, “Beijing thought it could buy its way out of the trade war by dramatically ramping up purchases of high-dollar U.S. goods it needed anyway, such as oil and gas, and by implementing modest reforms on market access and foreign investment.  China would happily buy as much “stuff” as it would take to allow Trump to claim victory on the deficit. Doing so would certainly be cheaper and easier than trying to bail out all the Chinese exporters that were about to get slammed by the U.S. tariffs at an economically inopportune time.”

“Reinforcing Beijing’s strategy was the (correct) belief that tariffs would take a financial toll on the U.S. too.  They would hurt U.S. consumers whose living standards had improved thanks to cheap Chinese goods, U.S. based firms dependent on inputs made in China, and U.S. owned exporters with factories in China.  Beijing assumed that  with [the 2018] midterm elections around the corner, Trump would have little appetite for a mutually destructive trade war that would rattle markets and put the White House at odds with constituencies such as farmers and free-traders that traditionally vote Republican. And this, Beijing hoped, would discourage the U.S. from pushing for structural overhauls in Chinese trade practices.”

However, Beijing’s strategy fell short.  Despite the fourth quarter stock market dip, “The U.S. economy is humming along at [near] the peak of the business cycle. The trade war has definitely hurt some U.S. sectors, and there will be long-term costs to the U.S. economy if it loses access to China’s gigantic consumer market - especially if other high-value exporting countries in Europe and Asia don’t face the same barriers. But the pain has been subtle enough, and trade policy esoteric enough, to prevent the trade war from becoming a major political issue.  In fact, the congressional districts in which trade influenced voters’ decisions tended to be the those that have benefited from new tariffs, particularly on steel and aluminum.”

More problematic for Beijing is a bipartisan recognition in the U.S. that China has stopped making progress on its WTO commitments and that the onus is on the U.S. to stop China from enjoying the benefits of the global trade system without abiding by its rules.  There’s also a growing consensus that Chinese practices such as forced technology transfers, outright technology theft, and its overt, state-backed “Made in China 2025″ plan to dominate high-tech industries are indeed a threat to U.S. interests and the “rules-based order” - even if there’s disagreement over whether punitive tariffs are an effective way to address them.

Add to this, widespread suspicion surrounding China’s broader geopolitical ambitions. For those who think Washington and Beijing are sliding inexorably toward a new Cold War, this means anything that weakens China is worthwhile?  For them, there is no compromise.

China, for its part, can’t make the sweeping changes Washington demands without giving up the tools it thinks it needs to solve its own political and economic problems.  And most importantly, Beijing thinks these problems far outweigh those created by losing access to the U.S. market.

Consider the facts: Beijing needs to be able to tightly control the yuan, intervene on behalf of domestic firms, and use the tools of the state to export excess industrial capacity; that’s the impetus for the Belt and Road Initiative, or BRI.  Large state-owned firms are needed to soak up excess labor.  To deal with rising wages, slowing growth and an unenviable demographic outlook, China must now make a mad dash up the manufacturing “value chain” into high-tech sectors.  Why?  Because during the decades when high-tech exporters like Japan, South Korea, Taiwan and Germany were moving to the technological and industrial vanguard, China was an isolated backwater.  Even today, it’s playing from behind, and the government is willing to do whatever it takes to skip to the front of the line.  That’s why China:

- forces foreign firms who want to operate in China to form joint ventures with local firms to maximize technology transfer

- supports commercial espionage and

- overtly shovels money into state-owned firms in industries deemed “strategic.”

The U.S. just doesn’t have the leverage to change China’s priorities.  The cost of U.S. tariffs is likely to be, at most, around 2-to-3 percent of GDP growth, each year.   Meanwhile, the cost of failing to keep people employed, moving into high-end exports and spurring sustainable long-term growth may well be the end of the Communist Party of China.

In response to this reality, Orchard argues that both “the U.S. and China are beginning to dramatically rewire their respective economies. The U.S. will stop indirectly helping China, either by creating incentives for multinational firms to reroute supply chains around China or by encouraging U.S. exporters to tailor their products to other markets (or both).  Most of what the U.S. buys from China is made by multinational firms, which will become more willing to take on the costs of relocating, if it becomes clear that tariffs are here to stay.  To expedite this process and bolster a rules-based global trading system, the U.S. will eventually once again embrace the benefits of multilateral trade blocs such as the TPP.”

Orchard goes on to observe that, “China, will have little choice but to shift focus to preserving market access in Europe and other wealthy states. It will also crack down on any social fallout from the intense, but ultimately temporary, disruption that follows, while hoping that increased domestic consumption will ease the pain. The truth is, China’s dependence on the U.S. market was already shrinking before the trade war even began, and rather than force Beijing to rethink its trade policies, that war has convinced the government that it must reduce its dependence on foreign markets and technology. With enough partners outside the U.S., and with enough money to throw at the challenge, it may actually succeed.”
 
However, this does not fully recognize the precarious reality facing president Xi, as he plays the world’s highest stakes game with the unpredictable Trump.   On Dec. 16, 2018 Prof. Xiang Songzuo of Renmin University School of Finance and former chief economist of China Agriculture Bank gave a powerful presentation to a gathering of Chinese executives.  

Xiang asked, “How bad are things? The numbers that China’s National Bureau of Statistics (or NBS) gives is 6.5 percent [growth], but just yesterday, a research group of an important institution released an internal report…They used two measurements. Going by the first estimate, China’s GDP growth this year was about 1.67 percent. And according to the other calculation, the growth rate was negative.” 

Xiang then went onto to address the enormous challenge facing the financial sector:

“Local debt is a big problem in China’s financial market. As for the actual number, the National Audit Office claims it to be about 17.8 trillion RMB, while He Keng, vice director of National People’s Congress Financial and Economic Affairs Committee, thinks it’s over 40 trillion RMB [or roughly $590 billion]. Worse yet, not one local government intends to pay back its debts.”
 
“Then, there’s also the stock market crash.  …an impending stock market rebound [is possible], but in my opinion, it’s far from forthcoming. You can look at the history: only the Wall Street Crash of 1929 can compare to the steep decline that the Chinese stock market has experienced this year. Many stocks are down 80 or even 90 percent.”

“… we know China’s stock market is feeling the pain, but what exactly is hurting?  … Look at our profit structure. To put it plainly, China’s listed companies don’t really make money. Then who has taken the few profits made by China’s more than 3,000 listed companies?  Two-thirds have been taken by the banking sector and real estate.”

“When we buy stocks, we are buying the profits of the company, not hype and rumors.  I recently read a report comparing the profits of China’s listed companies with those in the U.S. There are many U.S. public companies with tens of billions dollars in profits. How many Chinese tech and manufacturing companies are there that have accomplished this?  There is only one, and you all know which one that is. Huawei, but it’s not listed.  What does this tell us? As Yale professor Robert Shiller said: stock market performance may not work as a barometer of the economy in the short run, but it does, for sure, in the long run.”

“…terrible stock performance only demonstrates one thing, which is that the real economy in China is in quite a mess.”

Zhiang’s bottom line: Trump could hardly have picked a better time, strategically, to launch his trade offensive.

Given this trend we offer the following forecasts for your consideration.

First, the end-result of the current trade war will be a “more even playing field,” but it will not be the end of the struggle.

China lacks the staying power needed to overtly maintain its unfair trade practices.  Therefore, it will negotiate a set of adjustments that are both “face saving” and minimally disruptive.  As a result, the bi-lateral Sino-American trade deficit will nearly disappear, and foreign multinationals will gain greater, but still limited, access to Chinese consumer markets.  Meanwhile, Chinese promises to protect intellectual property, abandon coerced technology transfers and curb industrial espionage will only be honored to the extent that the United States works with the EU, Korea, Japan and others to identify and punish violations. 

Second, despite diverging geopolitical and economic interests, the United States and China will not fall back into a Cold War relationship.

If the U.S. cannot compel China to change, it will eventually lose interest in futile measures that cut off trade in areas where trade is mutually beneficial.   For instance, Cheap Chinese electronics are not a national security threat.  And the Chinese consumer market will remain nearly irresistible to U.S. exporters, especially in segments where the U.S. is the low-cost producer.   It’s easy to see the two countries settling on a limited, but largely healthy trade relationship in the future, even if the thornier points of contention never go away.  How we get to that point comes down to the broader geopolitical competition between the U.S. and China.
 
Third, by 2024, many of the biggest multinational exporters in China will decide they want no part of this Sino-Amercan battle and simply move to some other low-cost manufacturing hub.

According to a Peterson Institute for International Economics study, the first two rounds of U.S. tariffs disproportionately affected U.S. imports from China-based affiliates of multinational firms, rather than Chinese-owned firms.  Already, more than 70 percent of U.S. firms with operations in China surveyed, say they are mulling whether to delay or cancel new investments in China or leaving for greener, cheaper pastures altogether.  ? Where will they go? India perhaps comes closest to matching China’s competitive advantages. Last year, India’s labor force clocked in at a hefty 520 million people, and because of extreme class disparities, India can meet the labor cost needs of firms up and down the value chain.  It’s particularly competitive in the garment industry, thanks in part to robust local cotton production.  On the other hand, India’s strengths still lie mainly in services and low-end manufacturing because it still lacks the infrastructure needed for high-end manufacturing.  Due to factors like the convoluted regulatory environment, in 2017, India ranked just 77th on the World Bank’s Ease of Doing Business Index; that’s a jump of 23 spots over 2016, but it’s still well behind rankings of 46th for China, 27th for Thailand and 15th for Malaysia. So, despite India’s draws, only 6.5 percent of U.S. firms in China surveyed in a September 2018 report by the American Chamber of Commerce said they were considering relocating to India, compared to 18.5 percent for Southeast Asia.  And,
 
Fourth, while China’s Belt and Road Initiative (or BRI) will make it less vulnerable to U. S pressure, over the next decade, it will also politically isolate it from its neighbors.

BRI is designed to ensure open trade routes and alliances across Asia and even Europe.  Some BRI investments could also create potential military advantages for China, should China require access to selected foreign ports to pre-position the necessary logistics to support and sustain naval deployments in waters as distant as the Indian Ocean, Mediterranean Sea, and Atlantic Ocean to protect its growing interests.  Still, Chinese predatory lending, bribery, and reliance on Chinese labor are making Beijing’s political problems, with these countries more vexing.  And anti-ethnic-Chinese sentiments in a number of BRI states further complicate things.  -  A good example is the the China-Pakistan Economic Corridor, where Chinese and Pakistani relations are by no means smooth sailing.   The new government in Islamabad is already seeking to renegotiate the terms of the project. - A more important problem for China is that it’s encroaching on other powers’ traditional spheres of influence, and it’s not yet powerful enough to do so without spurring rival states into action.  For example, India won’t let China use BRI to tie up Sri Lanka, the Maldives, and Bangladesh, without a fight.  Similarly, Australia won’t permit China to control island nations across the South Pacific.  And Japan is strengthening ties with the Philippines, Thailand, Malaysia and Sri Lanka.
 
References
1. Breitbart.com.  January 21, 2019. John Hayward.  China Claims Economy ‘Resilient’ Despite Lowest Growth Since 1990.

https://www.breitbart.com/national-security/2019/01/21/china-claims-economy-resilient-despite-lowest-growth-since-1990/

2. Geopoliticalfutures.com.  Jan. 21, 2019.  Phillip Orchard.  The US-China Trade Fight Enters a New Round.

https://geopoliticalfutures.com/us-china-trade-fight-enters-new-round/

3. Geopoliticalfutures.com.  December 27, 2018.  Phillip Orchard.  In China, Manufacturers Feel the Heat of the Trade War.

https://geopoliticalfutures.com/china-manufacturers-feel-heat-trade-war/

4. Chinachange.org.  December 28, 2018.  Xiang Songzuo.  A Great Shift Unseen Over the Last Forty Years. 

https://chinachange.org/2018/12/28/a-great-shift-unseen-over-the-last-forty-years/

5. Geopoliticalfutures.com.  December 5, 2018.  Phillip Orchard.  In the US-China Trade War, a Cease-fire Ends Nothing.

https://geopoliticalfutures.com/us-china-trade-war-cease-fire-ends-nothing/

6. Geopoliticalfutures.com.  September 13, 2018.  Phillip Orchard.  The Limits of China’s Debt Trap.

https://geopoliticalfutures.com/limits-chinas-debt-trap/

7.  Geopoliticalfutures.com.  August 16, 2018.  Phillip Orchard.  One Belt, Many Headaches.

https://geopoliticalfutures.com/one-belt-many-headaches/